UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549

 

Form 10-K

 

 

Commission File Number 000-51205

 

DISCOVERY HOLDING COMPANY

(Exact name of Registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code:

(720) 875-4000

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act of 1933.  Yes þ     No o

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Exchange Act of 1934.  Yes o     No þ

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check One):

 

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act)  Yes o     No þ

 

The aggregate market value of the voting stock held by nonaffiliates of Discovery Holding Company computed by reference to the last sales price of such stock, as of the closing of trading on June 30, 2007, was approximately $6.1 billion.

 

The number of shares outstanding of Discovery Holding Company’s common stock as of January 31, 2008 was:

 

Series A Common Stock — 269,179,015; and

Series B Common Stock — 11,869,696 shares.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

The Registrant’s definitive proxy statement for its 2008 Annual Meeting of Stockholders is hereby incorporated by reference into Part III of this Annual Report on Form 10-K

 

 

DISCOVERY HOLDING COMPANY

 

2007 ANNUAL REPORT ON FORM 10-K

 

Table of Contents

 

 

 

 

Discovery Holding Company was incorporated in the state of Delaware on March 9, 2005 as a wholly-owned subsidiary of Liberty Media Corporation, which we refer to as Liberty. On July 21, 2005, Liberty completed the spin off of Discovery Holding Company to Liberty’s shareholders. In the spin off, each holder of Liberty common stock received 0.10 of a share of our Series A common stock for each share of Liberty Series A common stock held and 0.10 of a share of our Series B common stock for each share of Liberty Series B common stock held. Approximately 268.1 million shares of our Series A common stock and 12.1 million shares of our Series B common stock were issued in the spin off, which was intended to qualify as a tax-free transaction.

 

We are a holding company. Through our two wholly-owned operating subsidiaries, Ascent Media Group, LLC (“Ascent Media”) and Ascent Media CANS, LLC (dba AccentHealth) (“AccentHealth”), and through our 662/3% owned equity affiliate Discovery Communications Holding, LLC (“Discovery”), we are engaged primarily in (1) the provision of creative and network services to the media and entertainment industries and (2) the production, acquisition and distribution of entertainment, educational and informational programming and software. Our subsidiaries and affiliates operate in the United States, Europe, Latin America, Asia, Africa and Australia.

 

The assets and operations of Ascent Media are composed primarily of the assets and operations of 13 companies acquired by Liberty from 2000 through 2004, including The Todd-AO Corporation, Four Media Company, certain assets of SounDelux Entertainment Group, Video Services Corporation, Group W Network Services, London Playout Centre and the systems integration business of Sony Electronics. The combination and integration of these and other acquired entities allows Ascent Media to offer integrated outsourcing solutions for the technical and creative requirements of its clients, from content creation and other post-production services to media management and transmission of the final product to broadcast television stations, cable system head-ends and other destinations and distribution points.

 

AccentHealth, which we acquired in January 2006, operates an advertising-supported captive audience television network in doctor office waiting rooms nationwide.

 

Discovery is a leading global media and entertainment company that provides original and purchased programming across multiple distribution platforms in the United States and more than 170 other countries, including television networks offering customized programming in 35 languages. Discovery also develops and sells consumer and educational products and services in the United States and internationally, and owns and operates a diversified portfolio of website properties and other digital services. Discovery operates through three divisions: (1) Discovery networks U.S., (2) Discovery networks international, and (3) Discovery commerce and education.

 

Discovery was formed in the second quarter of 2007 as part of a restructuring (the “DCI Restructuring”) completed by Discovery Communications, Inc. (“DCI”). In the DCI Restructuring, DCI was converted into a limited liability company and became a wholly-owned subsidiary of Discovery, and the former shareholders of DCI, including us, became members of Discovery. Subsequent to the DCI Restructuring, each of the members of Discovery held the same membership interests in Discovery as they previously held in DCI. Discovery is the successor reporting entity to DCI.

 

On May 14, 2007, Discovery and Cox Communications Holdings, Inc. (“Cox”) completed an exchange of Cox’s 25% membership interest in Discovery for all of the capital stock of a subsidiary of Discovery that held Travel Channel, travelchannel.com and approximately $1.3 billion in cash (the “Cox Transaction”). Discovery raised the cash component through additional debt financing, and retired the membership interest previously owned by Cox. Upon completion of this transaction, we own a 662/3% interest in Discovery and Advance/Newhouse Programming Partnership (“Advance/Newhouse”) owns a 331/3% interest. We continue to account for our investment in Discovery using the equity method of accounting due to governance rights possessed by Advance/Newhouse which restrict our ability to control Discovery.

In December 2007, we announced that we had signed a non-binding letter of intent with Advance/Newhouse to combine our respective stakes in Discovery. As currently contemplated by the non-binding letter of intent, the transaction, if completed, would involve the following steps:

 

 

Although no assurance can be given, consummation of this transaction (the “Newhouse Transaction and Ascent Spin Off”) is expected to close in the second quarter of 2008 and would result in the consolidation of the results of Discovery within New DHC.

 

* * * * *

 

Certain statements in this Annual Report on Form 10-K constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements regarding our business, marketing and operating strategies, integration of acquired businesses, new service offerings, financial prospects and anticipated sources and uses of capital. In particular, statements under Item 1. “Business,” Item 1A. “Risk Factors”, Item 2. “Properties,” Item 3. “Legal Proceedings,” Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 7A. “Quantitative and Qualitative Disclosures About Market Risk” contain forward-looking statements. Where, in any forward-looking statement, we express an expectation or belief as to future results or events, such expectation or belief is expressed in good faith and believed to have a reasonable basis, but there can be no assurance that the expectation or belief will result or be achieved or accomplished. The following include some but not all of the factors that could cause actual results or events to differ materially from those anticipated:

 

 

 

These forward-looking statements and such risks, uncertainties and other factors speak only as of the date of this Annual Report, and we expressly disclaim any obligation or undertaking to disseminate any updates or revisions to any forward-looking statement contained herein, to reflect any change in our expectations with regard thereto, or any other change in events, conditions or circumstances on which any such statement is based. When considering such forward-looking statements, you should keep in mind the factors described in Item 1A, “Risk Factors” and other cautionary statements contained in this Annual Report. Such risk factors and statements describe circumstances which could cause actual results to differ materially from those contained in any forward-looking statement.

 

 

We identify our reportable segments based on financial information reviewed by our chief operating decision maker, or his designee. We report financial information for our consolidated business segments that represent more than 10% of our consolidated revenue or earnings before taxes and equity affiliates whose share of earnings represent more than 10% of our earnings before taxes.

 

Based on the foregoing criteria, our three reportable segments are our Creative Services group and Network Services group, which are operating segments of Ascent Media, and Discovery, which is an equity affiliate. Financial information related to our operating segments can be found in note 18 to our consolidated financial statements found in Part II of this report.

 

 

ASCENT MEDIA

 

Ascent Media provides a wide variety of creative and network services to the media and entertainment industries in the United States, the United Kingdom (“UK”) and Singapore. Ascent Media provides effective solutions for the creation, management and distribution of content to major motion picture studios, independent producers, broadcast networks, programming networks, advertising agencies and other companies that produce, own and/or distribute entertainment, news, sports, corporate, educational, industrial and advertising content. Services are marketed to target industry segments through Ascent Media’s internal sales force and may be sold on a bundled or individual basis.

 

Ascent Media’s operations are organized into two main categories: creative services and network services.

 

Ascent Media’s creative services group provides various technical and creative services necessary to complete principal photography into final products, such as feature films, movie trailers and TV spots, documentaries, independent films, scripted and reality television, TV movies and mini-series, television commercials, internet and new media advertising, music videos, interactive games and new digital media, promotional and identity campaigns and corporate communications. These services are referred to generally in the entertainment industry as “post-production” services. In addition, the creative services group provides a full complement of facilities and services necessary to optimize, archive, manage, and reformat and repurpose completed media assets for global distribution via freight, satellite, fiber and the Internet.

 

Ascent Media markets its creative services under various brand names that are generally well known in the entertainment industry, including Blink Digital, Cinetech, Company 3, Digital Media Data Center (DMDC), Digital Symphony, Encore Hollywood, FilmCore, Level 3 Post, Method, Modern Music, One Post, POP Sound, RIOT, Rushes, Soho Images, Soundelux, Soundelux Design Music Group (DMG), Sound One, St. Anne’s Post, Todd-AO and VisionText.

 

The creative services client base comprises major motion picture studios and their international divisions, independent television production companies, broadcast networks, cable programming networks, advertising agencies, creative editorial companies, corporate media producers, independent owners of television and film libraries and emerging new media distribution channels. The principal facilities of the creative services group are in Los Angeles, the New York metropolitan area and London, with additional facilities in Atlanta and San Francisco.

 

Key services provided by Ascent Media’s creative services group include the following:

 

Dailies.  Clients that are in production require daily screening of their previous day’s footage captured on film, video or data in order to evaluate technical and aesthetic qualities of the production and to facilitate the creative editorial process. Ascent Media provides the services necessary for clients to view principal photography on a daily basis, also known as “dailies”, including film processing and digital transfer, which is the transfer of film negatives to video or digital data. Dailies may be delivered to customers in a variety of videotape or file based formats. The Company also provides dailies viewing environments at client locations and in editorial cutting rooms for their clients’ productions.

 

Digital intermediates.  Ascent Media’s digital intermediate service provides customers with the ability to convert film to a high resolution digital master file for color correction, creative editorial and electronic assembly of masters in other formats. The digital intermediate process provides filmmakers and commercial producers with greater creative control through enhanced visual manipulation options and the ability to see their creative decisions applied in real time.

 

Color Correction.  The color correction process allows for the development of a creative look and feel for media content, which can then be applied to different source elements that are assembled in sequence to allow for consistency of visual presentation, notwithstanding variations in the original source material and the differing color spectrums of film and other media. Ascent Media employs highly-skilled creative talent who utilize creative colorizing techniques, equipment and processes to enable its clients to achieve desired results for creative content including television commercials, music videos, feature films and television shows.

 

Creative editorial.  After principal photography of advertising content has been completed, Ascent Media’s editors assemble various elements into a cohesive story consistent with the messaging, branding and creative direction of Ascent Media’s advertising clients. Ascent Media provides the tools and talent required through all stages of the “finishing” process necessary for creation, and primary and secondary distributions, of completed advertising content. Ascent Media also provides the rental of editorial equipment for use in the creation of feature film and episodic television content.

 

Visual effects.  Visual effects can be used to create images that cannot be created physically through a more cost-effective means, to digitally remove elements captured in principal photography, and to enhance or supplement original visual images by integrating computer generated images with images captured during

principal photography. Ascent Media provides its visual effects services with teams of artists utilizing an array of graphics and animation workstations and using a variety of software to accomplish unique effects.

 

Assembly, formatting and master creation and duplication.  Ascent Media implements clients’ creative decisions, including decisions regarding the integration of sound and visual effects, to assemble source material into its final form. In addition, Ascent Media uses sophisticated computer graphics equipment to generate titles and character imagery and to format certain entertainment media content to meet specific production and distribution requirements, including time compression and commercial breaks. Finally, Ascent Media creates and delivers multiple master copies of the applicable final product for distribution, broadcast, archival and other purposes designated by the customer.

 

Digital media management services.  Ascent Media’s Digital Media Data Center provides services that enable content owners to digitize content once, then store, manage, re-purpose and distribute such content globally in multiple formats and languages to numerous providers. These file-based services can help Ascent Media’s clients exploit existing and emerging global revenue streams, including broadband, mobile and other digital outlets and devices, reducing time-to-market while providing increased security, flexibility and database functionality. Such services can be implemented as a fully outsourced platform or individual managed services. As used in the media services industry, the term “element” refers to a unit of created content of any length, such as a feature film, television episode, commercial spot, movie trailer, promotional clip or other unique product, such as a foreign language version or alternate format of any of the foregoing.

 

Advertising distribution.  Once a television commercial has been completed, Ascent Media provides support services required to manufacture and deliver commercials to specific television broadcasters or radio stations, including format conversion, video and audio duplication, distribution, and storage and asset management, for advertising agencies, corporate advertisers and other content owners. Ascent Media uses satellite, fiber-optic and Integrated Services Digital Network, or ISDN, Internet access, terrestrial broadband, and conventional air freight for the delivery of television and radio spots to broadcasters and radio stations. Ascent Media’s commercial television distribution facilities in Los Angeles and San Francisco, California enable Ascent Media to service any regional or national client.

 

Restoration, preservation and asset protection of existing and damaged content.  Ascent Media provides film restoration, preservation and asset protection services. Ascent Media’s technicians use photochemical and digital processes to clean, repair and rebuild a film’s elements in order to return the content to its original and sometimes to an improved image quality. Ascent Media also protects film element content from future degradation by transferring the film’s image to newer archival film stocks or digital files. Ascent Media also provides asset protection services for its clients’ color library titles, which is a preservation process whereby B/W, silver image, polyester, positive and color separation masters are created, sufficiently protecting the images of new and older films.

 

Transferring film to video or digital media masters.  A considerable amount of film content is ultimately distributed to the home video, broadcast, cable or pay-per-view television markets. This requires film images to be transferred to a video or digital file format. Each frame must be color corrected and adapted to the desired aspect ratio to meet the required distribution specifications and ensure the highest level of conformity to the original film version. Because certain film formats require transfers with special characteristics, it is not unusual for a motion picture to be mastered in many different versions. Technological developments, such as the domestic introduction of television sets with a 16 X 9 aspect ratio and the implementation of advanced and high definition digital television systems for terrestrial and satellite broadcasting, have contributed to the growth of Ascent Media’s film transfer business. Ascent Media also digitally removes dirt and scratches from a damaged film master that is transferred to a digital file format.

 

Professional duplication and standards conversion.  Ascent Media provides professional duplication, which is the process of creating broadcast quality and resolution independent sub-masters for distribution to professional end users. Ascent Media uses master elements to make sub-masters in numerous domestic and international broadcast standards as well as up to 22 different tape formats. Ascent Media also provides standards conversion, which is the process of changing the frame rate of a video signal from one video standard, such as the United States standard (NTSC), to another, such as a European standard (PAL or

SECAM). Content is regularly copied, converted and checked by quality control for use in intermediate processes, such as editing, on-air backup and screening and for final delivery to cable and pay-per-view programmers, broadcast networks, television stations, airlines, home video duplicators and foreign distributors. Ascent Media’s duplication and standards conversion facilities are technically advanced with unique characteristics that significantly increase equipment capacity while reducing error rates and labor cost.

 

DVD compression and authoring and menu design.  Ascent Media provides all stages of DVD production, including creative menu design, special feature production, interactive features, compression, authoring, multi channel audio mixing, and quality control. Ascent Media supports DVD production in traditional DVD formats as well as Blu Ray and HD DVD formats. Ascent Media also prepares and optimizes content for evolving formats of digital distribution, such as video-on-demand and interactive television.

 

Storage of elements and working masters.  Ascent Media’s physical archives are designed to store working master videotapes and film elements in a highly controlled environment protected from temperature and humidity variation, seismic disturbance, fire, theft and other external events. In addition to the physical security of the archive, content owners require frequent and regular access to their libraries. Physical elements stored in Ascent Media’s archive are uniquely bar-coded and maintained in a library management database offering rapid access to elements, concise reporting of element status and element tracking throughout its travel through Ascent Media’s operations. Ascent Media also provides file-based digital archive services, as discussed under the heading Digital media management services above.

 

Syndicated television distribution.  Ascent Media’s syndication services provide AMOL-encoding and closed-captioned sub-mastering, commercial integration, library distribution, station list management and v-chip encoding. Ascent Media distributes syndicated television content by freight, satellite, fiber or the Internet, in formats ranging from low-resolution proxy streams to full-bandwidth high-definition television and streaming media.

 

Sound supervision, sound design and sound editorial.  Ascent Media provides creative talent, facilities and support services to enhance, modify or create sound for feature films, television content, commercials and trailers, interactive multimedia games and special live venues. Sound supervisors ensure that all aspects of sound, dialogue, sound effects and music are properly coordinated. Ascent Media’s sound services include, but are not limited to, sound editing, sound design, sound effect libraries, ADR (automated dialogue replacement, a process for recording dialogue in synchronization with previously recorded picture) and Foley (non-digital sound effects).

 

Music services.  Music services are an essential component of post-production sound. Ascent Media has the technology and talent to handle all types of music-related services, including original music composition, music supervision, music editing, scoring/recording, temporary sound tracks, composer support and preparing music for soundtrack album release.

 

Re-recording / Mixing.  Once sound editors, sound designers, composers, music editors, ADR and Foley crews have prepared the elements that will make up the finished product, the final process in the creative sound post production process is the mix (or re-recording). Mixing a film involves the process of combining multiple elements, such as tracks of sound effects, dialogue and music, to complete the final product. Ascent Media maintains a significant number of mixing stages, purpose-built and provisioned with advanced recording equipment, capable of handling any type of project, from major motion pictures to smaller independent films.

 

Sound effects and music libraries.  Through its Soundelux brand, Ascent Media maintains an extensive sound effects library with over 300,000 unique sounds, which editors and clients access through the company’s intranet and remotely via the Internet. The company also owns several production music libraries through its Hollywood Edge brand. Ascent Media’s clients use the sound effects and music libraries in feature films, television shows, commercials, interactive and multimedia games. Ascent Media actively continues to add new, original recordings to its library.

 

Ascent Media’s network services group provides origination, transmission/distribution and technical services to broadcast, cable and satellite programming networks, local television channels, broadcast syndicators, satellite broadcasters, government, other broadband telecommunications companies and corporations that operate private networks. Ascent Media’s network services group operates from facilities located in California, Connecticut, Florida, Minnesota, New York, New Jersey, Virginia and the United Kingdom and Singapore.

 

Key services provided by Ascent Media’s network services group include the following:

 

Network origination and master control.  The network services group provides outsourced network origination services to cable, satellite and pay-per-view programming networks. Ascent Media accepts daily program schedules, programs, promotional materials and advertising and transmits 24 hours of seamless daily programming to cable operators, direct broadcast satellite systems and other destinations via fiber and satellite. Currently, over two hundred programming feeds — running 24 hours a day, seven days a week — are supported by Ascent Media’s facilities in the United States, London and Singapore. Network origination services are provided from large-scale technical platforms with integrated asset management, hierarchical storage management (a data storage technique which automatically moves data between high-cost and low-cost storage media), and broadcast automation capabilities. These platforms, which are designed, built, owned and operated by Ascent Media, require Ascent Media to incorporate and integrate hardware and software from multiple third-party suppliers into a coordinated service solution. Associated services include cut-to-clock and compliance editing, tape library management, ingest & quality control, format conversion, and tape duplication. For multi-language television services, Ascent Media facilitates the collection, aggregation, and playout of languaging materials, including subtitles and foreign language dubs. On-air graphics and other secondary events are also integrated with the content by Ascent Media. In conjunction with network origination services, Ascent Media operates television production studios and provides complete post-production services for on-air promotions for some clients.

 

Transport and connectivity.  Ascent Media operates satellite earth station facilities in Singapore, California, New York, New Jersey, Minnesota and Connecticut. Ascent Media’s facilities are staffed 24 hours a day and may be used for uplink, downlink and turnaround services. Ascent Media accesses various “satellite neighborhoods,” including basic and premium cable, broadcast syndication, direct-to-home and DBS markets. Ascent Media resells transponder capacity for occasional and full-time use and bundles its transponder capacity with other broadcast and syndication services to provide a complete broadcast package at a fixed price. Ascent Media’s “teleports” are high-bandwidth communications gateways with video switches and facilities for satellite, optical fiber and microwave transmission. Ascent Media’s facilities offer satellite antennae capable of transmitting and receiving feeds in both C-Band and Ku-Band frequencies. Ascent Media operates a global fiber network to carry real-time video and data services between its various locations in the US, London, and Singapore. This network is used to provide full-time program feeds and ad hoc services to clients and to transport files and real-time signals between Ascent Media locations. Ascent Media also operates industry-standard encryption and/or compression systems as needed for customer satellite transmission.

 

Engineering and systems integration.  Ascent Media designs, builds, installs and services advanced technical systems for production, management and delivery of rich media content to the worldwide broadcast, cable television, broadband, government and telecommunications industries. Ascent Media’s engineering and systems integration business operates out of facilities in New Jersey, California, Florida, and London, and services global clients including major broadcasters, cable and satellite networks, telecommunications providers, and corporate television networks, as well as numerous production and post-production facilities. Services offered include program management, engineering design, equipment procurement, software integration, construction, installation, service and support. Ascent Media also designs and constructs satellite earth stations and related facilities.

 

Consulting Services.  Ascent Media provides strategic, technology and business consulting services to the media and entertainment industry. Key practice areas include: digital migration; content delivery strategies; workflow analysis and design; emerging delivery platforms (such as Internet-protocol television, mobile and broadband); technology assessment; and technology-enabled business strategies.

Network Operations, Field Service and Call Center.  The network services group provides field service operations — 24 hours a day, seven days a week — through an on-staff network of approximately 50 field engineers located throughout the United States. Services include preventative and reactive maintenance of satellite earth stations, satellite networks, fiber-based digital transmission facilities, cable and telecommunications stations (also called head ends), and other technical facilities for the distribution of video content. The group operates a call center — 24 hours a day, seven days a week — out of its Palm Bay, Florida facility, providing outsourced services for technology manufacturing companies, networks and telecoms. In addition, the group operates a network operations center, providing outsourced services relating to monitoring and management of satellite and terrestrial distribution networks and remote monitoring and control of technical facilities. End users for field service, call center and network operation center services include major US broadcast and cable networks, telecommunications providers, digital equipment manufacturers, and government and corporate operations.

 

 

AccentHealth provides advertising-supported health education programming for distribution in doctor office waiting rooms via three AccentHealth Waiting Room TV Networks: the General Health Network, the Young Family Network and the Silver Network. The General Health Network targets general practice and family practice patients, and provides news and health information applicable to the general needs of that demographic. The Young Family Network targets pediatric and Ob-Gyn patients, and provides baby, child and parenting related programming. The Silver Network targets internal medicine, general practice and cardiology patients, and provides programming tailored to appeal to the specific interests of patients over the age of 50. Programming on the AccentHealth Waiting Room TV Networks is produced monthly by CNN and features customized content relating to a variety of topics, including medical breakthroughs, parenting issues, nutrition, fitness, safety and wellness.

 

AccentHealth’s programming content airs on television monitors installed in doctor office waiting rooms, and is provided at no cost to the practice. AccentHealth offers its advertising clients a number of products and services, including:

 

 

We believe that AccentHealth is the largest point-of-care media supplier in the U.S., with the AccentHealth Waiting Room TV networks reaching 11.7 million viewers per month in 11,200 waiting rooms nationwide.

 

 

Ascent Media’s goal is to be the premier end-to-end digital media supply chain services provider to the media and entertainment industry — creating, managing and distributing rich media content across all distribution channels on a global basis. Ascent Media believes it can optimize its position in the market by pursuing the following strategies:

 

Provide a broad range of media services.  The entertainment services industry has historically been fragmented, with numerous providers offering discrete, geographically-limited, non-integrated services. Ascent Media spans the value chain with a broad range of services from the creation and management of media content to the distribution of content via multiple transmission paths, including satellite, fiber and Internet Protocol-based networks on a global basis. Ascent Media believes its range of service offerings and in-depth knowledge of media workflows provide it with a strategic advantage over less-diversified service providers in developing deep, long-term relationships with creators, owners and distributors of creative content. In addition, Ascent Media believes that the reputations of its highly-respected creative boutiques, which operate under their own well-known brand names, help distinguish Ascent Media from commodity suppliers.

Grow digital media management business.  Ascent Media seeks to increase business with major media and entertainment clients by creating, storing, managing, repurposing and distributing their digital media content through traditional channels as well as emerging new media outlets on a global basis. Ascent Media believes that the technical complexity and scale issues associated with providing these services will make outsourcing of activities more attractive to Ascent Media’s client base, creating opportunities for increased market share. In 2007, Ascent Media extended the geographical reach of its proprietary digital media management system, adding capabilities in the New York metropolitan area and the United Kingdom to the original center in Los Angeles. Ascent Media currently plans to deploy its proprietary digital media management system in Singapore during 2008.

 

Deploy an interconnected global media network.  Ascent Media plans to provide clients access to a fiber-based network integrated with its creative and management services. The network will provide global connectivity and file transport capabilities, which will make client workflows more efficient and enhance Ascent’s end-to-end portfolio of services.

 

Invest in core business operations.  Ascent Media intends to increase its capabilities through internal investments to improve the capacity, utilization and throughput of its existing facilities. Ascent Media will also consider opportunities that may arise to add scale or service offerings, or to increase market share, through strategic acquisitions or joint ventures. Consistent with this strategy, Ascent Media will also seek opportunities to divest non-core assets, when appropriate.

 

Seek opportunities to offer new services within core competencies.  Ascent Media intends to expand its market share by applying its core capabilities to develop new value-added service offerings, participating in emerging high revenue-generating services such as re-versioning content for distribution to new platforms. In that regard, Ascent Media will endeavor to develop service offerings that meet unique needs of its customers.

 

For a description of the risks associated with the foregoing strategies, and with Ascent Media’s business in general, see “Risk Factors” beginning on page I-27.

 

 

The demand for Ascent Media’s core motion picture services, primarily in its creative services group, has historically been seasonal, with higher demand in the spring (second fiscal quarter) and fall (fourth fiscal quarter), and lower demand in the winter and summer. Similarly, demand for Ascent Media’s television program services, primarily in its creative services group, is higher in the first and fourth quarters and lowest in the summer, or third quarter. Demand for Ascent Media’s commercial services, primarily in its creative services group, are fairly consistent with slightly higher activity in the third quarter. However, changes in the timing of the demand for television program services may result in increased business for Ascent Media in the summer. In addition, the timing of long-term projects in Ascent Media’s creative services group are beginning to offset the quarters in which there has been historically lower demand for Ascent Media’s motion picture and television services. Accordingly, Ascent Media expects to experience less dramatic quarterly fluctuations in its operating performance in the future.

 

DISCOVERY

 

Discovery is a leading global media and entertainment company that provides original and purchased programming across multiple distribution platforms in the United States and more than 170 other countries, with over 100 television networks offering customized programming in 35 languages. As one of the world’s largest providers of non-fiction television programming, Discovery’s strategy is to optimize the distribution, ratings and profit potential of each of its branded channels. Discovery also develops and sells consumer and educational products and services in the United States and internationally, and owns and operates a diversified portfolio of website properties and other digital services. Discovery operates through three divisions: (1) Discovery networks U.S., (2) Discovery networks international, and (3) Discovery commerce and education.

 

Discovery’s media content spans non-fiction genres including science, exploration, survival, natural history, sustainability of the environment, technology, anthropology, health and wellness, engineering, adventure, lifestyles and current events. This type of programming tends to be culturally neutral and maintains its relevance for an extended period of time, referred to as “long-tail.” As a result, Discovery’s content translates well across

international borders and is made even more accessible through extensive use of dubbing and subtitles in local languages as well as the creation of local programming tailored to individual market preferences.

 

Discovery’s content is designed to target key audience demographics, and the popularity of its programming offers a compelling reason for advertisers to purchase time on its channels. Discovery’s audience ratings are a key driver in generating advertising revenue and create demand on the part of cable television operators, direct-to-home or “DTH” satellite operators, telephone and communications companies and other content distributors to deliver its programming to their customers.

 

Discovery has an extensive library of over 100,000 hours of programming and footage that provides a high-quality source of content for creating new services and launching into new markets and onto new platforms. Discovery generally owns most or all rights to the majority of this programming and footage which enables Discovery to exploit its library to launch new brands and services into new markets quickly without significant incremental spending. Programming can be re-edited and updated to provide topical versions of subject matter in a cost-effective manner and utilized around the world.

 

In addition to growing distribution and advertising revenue for its branded channels, Discovery is focused on growing revenue across new distribution platforms, including brand-aligned web properties, mobile devices, video-on-demand and broadband channels, which serve as additional outlets for advertising and affiliate sales, and provide promotional platforms for its programming. Discovery currently operates Internet sites providing news, information and entertainment content that are aligned with its television programming. In December 2007, Discovery completed the acquisition of HowStuffWorks.com, an award-winning online source of high-quality, unbiased and easy-to-understand explanations of how the world actually works. This acquisition provides an additional platform for Discovery’s extensive library of video content and positions its brand as a hub for satisfying curiosity on a variety of topics on both television and online.

 

Discovery is also exploiting its programming assets to take advantage of the growing demand for high definition (HD) programming in the U.S. and throughout the world. In 2007, Discovery launched HD simulcasts of four of its networks (Discovery Channel, TLC, Animal Planet and Science Channel) in addition to its existing HD Theater service, which was launched in 2002. Discovery also operates HD channels in 15 countries outside of the U.S., making it the number-one programming provider of HD channels outside of the U.S. based on the number of HD channels that it operates. Discovery believes it is well positioned to take advantage of the accelerating growth in sales of HD televisions and Blu-Ray and HD DVD players, and the expanding distribution of HD channels around the world. Where Discovery operates HD simulcasts of its networks, Discovery also benefits from the ability to aggregate audiences for advertising sales purposes.

 

 

Discovery’s strategy is to develop high quality media brands that build consumer viewership, optimize distribution growth and capture advertising sales. In addition, Discovery is focused on maximizing the overall efficiency and effectiveness of its global operations through collaboration and innovation across operating units and regions around the world and across all television and digital platforms.

 

In line with this strategy, Discovery’s specific priorities include:

 

 

 

 

In support of its strategy and priorities, in January 2007, Discovery re-evaluated its operations to identify and implement strategic initiatives designed to improve operational and financial performance and allocate capital in a more disciplined and efficient manner. The following actions are representative of these initiatives:

 

 

 

 

Discovery operates through the three divisions discussed below. A discussion of the financial performance of each of these divisions can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

 

Reaching approximately 675 million cumulative subscribers (as defined below) in the United States as of December 31, 2007 and having one of the industry’s most widely distributed portfolio of brands, Discovery networks U.S. delivers 11 cable and satellite television channels in the U.S. The portfolio includes three channels that each reach over 90 million U.S. subscribers (as defined below) and four channels that each reach over 50 million U.S. subscribers. Discovery networks U.S. also provides distribution and advertising sales services for Travel Channel and BBC America and distribution services for BBC World Service.

 

Domestic subscriber numbers set forth in this document are according to The Nielsen Company. As used herein, a “U.S. subscriber” is a single household that receives the applicable Discovery channel from its cable, satellite or other television provider, including those who receive Discovery networks from pay-television providers without charge pursuant to various pricing plans that include free periods and/or free carriage. The term “cumulative subscribers” in the U.S. refers to the collective sum of the total number of U.S. subscribers to each of Discovery’s U.S. channels. By way of example, two U.S. households that each receive five Discovery networks from their cable provider represent 10 cumulative subscribers in the U.S. The term cumulative subscribers in the U.S. also includes seven million cumulative subscribers in Canada who receive direct feeds of TLC and Military Channel from Discovery networks U.S.

 

 

 

 

 

 

 

 

 

 

 

Discovery’s U.S. networks are wholly owned by Discovery except for (1) Animal Planet, which is co-owned with DHC (10%) and Advance/Newhouse (5%) and (2) OWN Network, which would be a 50-50 joint venture between Discovery and Harpo, Inc.

 

Discovery networks U.S. also includes Discovery’s digital media businesses in the United States, which feature three main components: (1) organic channel websites such as Discovery.com, TLC.com and AnimalPlanet.com and acquired assets including HowStuffWorks.com, TreeHugger.com and Petfinder.com; (2) Discovery Mobile, Discovery’s mobile video service; and (3) Discovery on-demand, a free on demand service featuring content from across Discovery’s stable of U.S. networks.

 

Discovery’s digital media business is an increasingly important part of Discovery’s business, given the broad cross-platform sales and promotional opportunities with Discovery’s television networks and the reach of the websites themselves, coupled with the economies realized through programs that can be produced once and used often in both long- and short-term formats across multiple platforms.

The U.S. Internet traffic data set forth herein is according to Omniture, Inc. Discovery’s digital assets include:

 

 

 

 

Discovery networks U.S. also has distribution arrangements with the majority of mobile carriers in the U.S. to provide unique made-for-mobile short-form content and long-form episodes of popular titles on mobile devices. Discovery’s video-on-demand service is distributed across most major U.S. affiliates, offering a selection of full-length programming such as Discovery Channel’s Mythbusters and Deadliest Catch.

 

Reaching approximately 810 million cumulative subscribers (as defined below) in over 170 countries outside the U.S as of December 31, 2007, Discovery networks international operates one of the most extensive international television businesses in the media industry and executes a localization strategy by offering customized programming and in-market schedules via more than 100 unique distribution feeds and 35 languages. Discovery networks international encompasses five regional operations covering all major foreign cable and satellite markets, including Asia-Pacific, India, Latin America, the UK and EMEA (Europe, the Middle East and Africa), and has more than 25 international offices with regional headquarters located in Singapore, New Delhi, Miami and London.

 

International subscriber statistics are derived from internal data review coupled with external sources when available. As used herein, an “international subscriber” is a single household that receives the applicable Discovery network or programming service from its cable, satellite or other television provider, including those who receive Discovery networks from pay-television providers without charge pursuant to various pricing plans that include free periods and/or free carriage. The term “cumulative subscribers” outside the U.S. refers to the collective sum of the total number of international subscribers to each of Discovery’s networks or programming services outside of the U.S. By way of example, two international households that each receive five Discovery networks from their cable provider represent 10 cumulative subscribers outside the U.S. Cumulative subscribers outside the U.S. include subscriptions for branded programming blocks in China, which are generally provided without charge to third-party channels and represented approximately 280 million cumulative subscribers outside the U.S. as of December 31, 2007.

 

Discovery’s international networks are wholly owned by Discovery except (1) the international Animal Planet channels which are generally 50-50 joint ventures with the BBC, (2) People+Arts which operates in Latin America and Iberia as a 50-50 joint venture with the BBC and (3) several channels in Japan, Canada and Poland which operate as joint ventures with strategic local partners and which are not consolidated in Discovery’s financial statements but whose subscribers are included in Discovery’s international cumulative subscribers. Pursuant to the terms of the Animal Planet international joint ventures, BBC has the right, subject to certain conditions, to cause Discovery to acquire BBC’s interest in these joint ventures. Pursuant to the terms of the People + Arts joint venture, BBC has the right, subject to certain conditions, to cause Discovery to either acquire BBC’s interest in, or sell to the BBC Discovery’s interest in, this joint venture. Certain preliminary steps have been taken with respect to the exercise by BBC of its rights; however, we cannot assure you whether the conditions to the exercise of either or both of these rights will be satisfied or if they are satisfied whether BBC will exercise either or both of these rights.

 

Led by flagship brand Discovery Channel, Discovery networks international distributes 16 network entertainment brands, including:

 

 

 

 

 

 

Discovery networks international also includes the following television channels: Discovery Civilization, Discovery Geschichte, Discovery Historia, Discovery Knowledge, Discovery Turbo, and DMAX UK.

 

The following Spanish-language networks are distributed to U.S. subscribers, but are operated by and included as part of Discovery networks international for financial reporting and management purposes:

 

 

Discovery networks international also operates Antenna Audio which was acquired by Discovery in 2006, and is a leading provider of audio and multimedia tours to museums, exhibitions, historic sites and visitor attractions around the world. Each year, more than 20 million visitors purchase Antenna Audio’s tours in 12 languages across 20 countries at approximately 450 of the world’s most famous, fascinating and frequented locations, including museums such as the Metropolitan Museum of Art, the Musée du Louvre and Tate; historic and cultural sites including Graceland, Château de Versailles and Alcatraz; and popular destinations such as the Statue of Liberty and Yosemite National Park.

 

Discovery networks international’s digital business is in its early stages of development. Discovery’s international websites currently function as marketing vehicles for the network brands. Discovery networks international also operates a program sales business pursuant to which it sells programming internationally and a licensing business pursuant to which it licenses its brands for consumer products internationally.

Discovery Commerce and Education

 

 

Discovery commerce represents an additional revenue stream for Discovery. It also plays an important role in support of Discovery’s overall strategic objectives by driving consumers to Discovery’s television and online properties and instilling viewer loyalty. In 2007, as part of a company-wide strategic review, Discovery made the decision to discontinue its brick-and-mortar retail stores and instead focus on exploiting its on-air brands and increasing the reach of its products through its e-commerce platform and licensing arrangements. In the third quarter of 2007, Discovery completed the closing of its 103 mall-based and stand-alone Discovery Channel stores.

 

The division’s platforms now include an e-commerce business, seasonal catalogs and domestic licensing business:

 

 

 

Discovery education provides video-based broadband educational content through subscription services to public and private K-12 schools serving over one million teachers nationwide. Discovery’s flagship educational service, Discovery Education streaming, is an online video-on-demand teaching service that features 4,000 digital videos and 40,000 content specific video clips correlated to state K-12 curriculum standards.

 

Discovery education also publishes and distributes content on DVD, VHS, and CD-ROM through catalogs, an online teacher store, and a network of distributors. Discovery education also participates in licensing and sponsorship programs with corporate partners and supports Discovery’s digital initiatives by providing educational content in multiple formats that meet the needs of teachers and students.

 

 

Discovery’s content development strategy is designed to increase viewership, maintain innovation and quality leadership, and provide value for its distributors and advertising customers. Discovery’s production agreements fall into three categories: commissions, co-productions and acquisitions. Commissions refer to programming for which Discovery generally owns most or all rights for at least 10 years and, in exchange for paying for all production costs, retains all editorial control. Co-productions refer to programs where Discovery retains significant (but more limited) rights to exploit the programs. The rights package retained by Discovery is generally in proportion to the portion of the total project costs covered by Discovery, which generally ranges from 25-70% of the total project cost. Co-productions are typically high-cost projects for which neither Discovery nor its co-producers wish to bear the entire cost or productions in which the producer has already taken on an international broadcast partner. Acquisitions are license agreements for films or series that have already been produced.

 

As revenue and network distribution grows, Discovery’s program mix matures from acquired content to sharing in co-productions to full commissions. To minimize programming expense in the early stages, as an audience base begins to form, acquired programming is used to a greater extent and repeated frequently. The

transition from acquired content provides for more customized use of programming for individual networks and broader rights for re-use on television networks and new platforms.

 

Discovery sources content from a wide range of producers, building long-standing relationships with some of the world’s leading non-fiction production companies as well as consistently developing and encouraging young independent producers. Discovery also has long-term relationships with some of the world’s most significant non-fiction program producers, including the British Broadcasting Corporation.

 

The programming schedule on Discovery’s most widely distributed networks is mostly a mix of high-cost “special event” programming combined with miniseries and regular series. Large-scale programming events such as Planet Earth, Nefertiti Resurrected, Walking With Cavemen and Blue Planet bring brand prestige, favorable media coverage and substantial cross-promotional opportunities for other content platforms. Given the success of these global programming “tent-poles,” Discovery will continue to invest in a mix of programs that have the potential to draw larger audiences while also increasing the investment in regularly scheduled series. Brand-defining series such as Mythbusters, Dirty Jobs, Deadliest Catch, What Not To Wear, Man Vs Wild, John And Kate Plus 8 and Little People, Big World bring predictability to the schedule, increase repeat viewership and channel loyalty, and create new sub-brands that can be exploited and monetized across other platforms and around the world.

 

Discovery has an extensive library of over 100,000 hours of programming and footage that provides a high-quality source of programming for debuting new services quickly without significant incremental spending. For example, Discovery was able to exploit the “long-tail” popularity of its extensive non-fiction library of forensics and investigation programming to debut the re-branded Investigation Discovery channel in January 2008. Programming can be re-edited and updated to provide topical versions of subject matter in a cost-effective manner. Library development also provides a mechanism to share program ideas around the world and repurpose for display on new digital and mobile platforms.

 

 

Discovery earns revenue principally from (1) the receipt of affiliate fees from the global delivery of non-fiction programming pursuant to affiliation agreements with cable television operators, direct-to-home satellite operators and other distributors, (2) advertising sales on its television networks and websites and (3) product and subscription sales in the commerce and education businesses. No single customer represented more than 10% of Discovery’s consolidated revenue for the year ended December 31, 2007.

 

 

Distribution revenue represented 47% of Discovery’s consolidated total revenue in 2007. Distribution revenue in the U.S. represented 44% of U.S. networks revenue, and international distribution fees represented 60% of international networks revenue in 2007. Distribution revenue is generated through affiliation agreements with cable, satellite and other television distributors, which have a typical term of 3-7 years. These affiliation agreements generally provide for the level of carriage Discovery’s networks will receive, such as channel placement and package inclusion (whether on more widely distributed, broader packages or lesser-distributed, specialized packages), and for payment of a fee to Discovery based on the numbers of subscribers that receive its networks. Upon the launch of a new channel, Discovery may initially pay distributors to carry such channel (such payments are referred to as “launch incentives”), or may provide the channel to the distributor for free for a predetermined length of time. Discovery has long-term contracts with distributors representing most cable and satellite operators around the world, including the largest operators in the U.S. and major international distributors. In the U.S., 90% of distribution revenue comes from the top eight distributors, with whom Discovery has agreements that expire at various times beginning in 2008 through 2014. In 2008, Discovery will enter negotiations to renew distribution agreements for carriage of its networks involving a substantial portion of its domestic subscribers. A failure to secure a renewal or a renewal on less favorable terms may have a material adverse effect on Discovery’s results of operations and financial position. Outside of the U.S., Discovery has agreements with numerous distributors with no individual agreement representing more than 10% of Discovery’s international distribution revenue.

 

Advertising revenue comprised 43% of Discovery’s consolidated total revenue in 2007. Advertising revenue in the U.S. represented 51% of U.S. networks revenue, and international advertising revenue represented 32% of international networks revenue in 2007. Discovery typically builds network brands by securing as broad a subscriber base as possible. After obtaining sufficient distribution to provide an attractive platform for advertising, Discovery increases its investment in programming and marketing to build audience share and drive strong ratings performance in order to increase advertising sales opportunities. Advertising revenue generated by each program service depends on the number of subscribers receiving the service, viewership demographics, the brand appeal of the network and ratings as determined by third-party research companies such as The Nielsen Company. Revenue from advertising is subject to seasonality and market-based variations. Advertising revenue is typically highest in the second and fourth quarters. Revenue can also fluctuate due to the popularity of particular programs and viewership ratings. In some cases, advertising sales are subject to ratings guarantees requiring Discovery to provide additional advertising time or refunds if the guarantees are not met.

 

Discovery sells advertising time in both the upfront and scatter markets. In the upfront market, advertisers buy advertising time for the upcoming season, and by buying in advance, often receive discounted rates. In the scatter market, advertisers buy advertising time close to the time when the ads will be run, and often pay a premium. The mix between the upfront and scatter markets is based upon a number of factors such as pricing, demand for advertising time and economic conditions.

 

The company’s two flagship networks, Discovery Channel and TLC, target key demographics that have historically been considered attractive to advertisers, notably viewers in the 18-54 age range who are viewed as having significant spending power. The Discovery Channel’s target audience skews toward male viewers, while TLC targets female viewers, providing a healthy gender balance in Discovery’s portfolio for distribution and advertising clients.

 

Discovery benefits by having a portfolio of networks appealing to a broad range of demographics. This allows Discovery to create advertising packages that exploit the strength of its large networks to benefit smaller niche or targeted networks and networks on digital tiers. Utilizing the strength of its diverse networks, coupled with its online and digital platforms, Discovery seeks to create innovative programming initiatives and multifaceted campaigns for the benefit of a wide variety of companies and organizations who desire to reach key audience demographics unique to each network. Discovery delivers customized, integrated marketing campaigns to clients worldwide by catering to the special needs of multi-regional advertisers who are looking for integrated campaigns that move beyond traditional spot advertising to include sponsorships, product placements and other opportunities.

 

Discovery also generates advertising revenue from its websites. Discovery sells advertising on its websites both on a stand-alone basis and as part of advertising packages with its television networks.

 

 

Discovery commerce and education derives revenue principally from the sale of products online and through its catalogs, licensing royalties and subscriptions to its educational streaming services. As part of its commerce business, Discovery has a domestic consumer products licensing business which licenses Discovery’s brands in connection with merchandise, videogames and publishing. Discovery is generally paid a royalty based upon a percentage of its licensees’ wholesale revenues, with an advance against future expected royalties. As part of its strategic reorganization described above, Discovery closed its 103 retail stores in 2007.

 

E-commerce and catalog sales are highly seasonal with a majority of the sales occurring in the fourth quarter due to the holiday season. Licensing revenue may vary from period to period depending upon the popularity of the properties available for license and the popularity of licensed products in a particular period. Subscription sales to Discovery’s educational streaming services are primarily sold at the beginning of each school year as school budgets are appropriated and approved. The revenue derived from the subscription agreements are generally recognized over the school year. Discovery education also provides products that are sold throughout the school year. In 2007, revenue from e-commerce and catalog sales (excluding sales from Discovery’s retail stores which

were closed in 2007), licensing and education subscriptions was 54%, 5% and 27%, respectively, of total revenue for Discovery commerce and education.

 

 

Discovery’s principal operating costs consist of programming expense, sales and marketing expense, personnel expense and general and administrative expenses. Content amortization expense is Discovery’s largest category, representing 35% of Discovery’s 2007 consolidated operating expenses, as investment in maintaining high-quality editorial and production values is a key differentiator for Discovery content. In connection with creating original content, Discovery incurs production costs associated with acquiring new show concepts and retaining creative talent, including actors, writers and producers. Discovery also incurs higher production costs when filming in HD versus standard definition. Discovery incurs sales and marketing expense to promote brand recognition and to secure quality distribution channels worldwide.

 

 

A subsidiary of ours, together with Advance/Newhouse and John Hendricks, the founder and Chairman of Discovery, are parties to a Limited Liability Company Agreement. We own 662/3% and Advance/Newhouse owns 331/3% of Discovery. Mr. Hendricks is the record holder of one membership interest of Discovery; however, Mr. Hendricks cannot transfer this interest, the interest is subject to an irrevocable proxy in favor of Advance/Newhouse and the interest is subject to a call arrangement pursuant to which Advance/Newhouse can purchase the interest. Accordingly, we treat such interest as being owned by Advance/Newhouse for purposes of Advance/Newhouse’s percentage ownership of Discovery as described in this Annual Report. The Limited Liability Company Agreement provides that a number of decisions affecting Discovery, such as, among other things, a decision to effect a fundamental change in its business, a merger or other business combination, issuance of Discovery’s equity securities, approval of transactions between Discovery, on the one hand, and any of its stockholders, on the other hand, and adoption of Discovery’s annual business plan or payment of any distributions on the membership interests must be approved by the holders of 80% of its outstanding membership interests. Because we own 662/3% and Advance/Newhouse owns 331/3% of Discovery, either one of us may block Discovery from taking any action that requires 80% approval.

 

The Limited Liability Company Agreement also restricts, subject to certain exceptions, the ability of a member to transfer its membership interests in Discovery to a third party. Any such proposed transfer is subject to a pro rata right of first refusal in favor of the other member. If all of the offered membership interests are not purchased by the other member, then the selling member may sell all of the offered membership interests to the third party that originally offered to purchase such interests at the same price and on the same terms, provided that such third party agrees to be bound by the restrictions contained in the Limited Liability Company Agreement.

 

The Limited Liability Company Agreement also prohibits Advance/Newhouse and our company from starting, or acquiring a majority of the voting power of, a basic programming service carried in the United States that consists primarily of documentary, science and nature programming, subject to certain exceptions.

 

In connection with our spin off from Liberty, Liberty contributed to us 100% of an entity that owns a 10% interest in the Animal Planet limited partnership. Our partners in this entity include Discovery and Advance/Newhouse. The Limited Liability Company Agreement prohibits us from selling, transferring or otherwise disposing of either of the subsidiaries that hold the Discovery interest or Animal Planet interest, respectively, unless, after such transaction, such subsidiaries are controlled by the same person or entity.

 

The foregoing summary of the Discovery Limited Liability Agreement is qualified by reference to the full text of the agreement and amendments.

 

REGULATORY MATTERS

 

 

Some of Ascent Media’s subsidiary companies hold licenses and authorizations from the Federal Communications Commission, or FCC, required for the conduct of their businesses, including earth station and various

classes of wireless licenses and an authorization to provide certain services pursuant to Section 214 of the Communications Act. Most of the FCC licenses held by such subsidiaries are for transmit/receive earth stations, which cannot be operated without individual licenses. The licenses for these stations are granted for a period of fifteen years and, while the FCC generally renews licenses for satellite earth stations, there can be no assurance that these licenses will be renewed at their expiration dates. Registration with the FCC, rather than licensing, is required for receiving transmissions from domestic satellites from points within the United States. Ascent Media relies on third party licenses or authorizations when it and its subsidiaries transmit domestic satellite traffic through earth stations operated by third parties. The FCC establishes technical standards for satellite transmission equipment that change from time to time and requires coordination of earth stations with land-based microwave systems at certain frequencies to assure non-interference. Transmission equipment must also be installed and operated in a manner that avoids exposing humans to harmful levels of radio-frequency radiation. The placement of earth stations or other antennae also is typically subject to regulation under local zoning ordinances.

 

 

Discovery’s businesses are subject to and affected by regulations of U.S. federal, state and local government authorities, and Discovery’s international operations are subject to laws and regulations of local countries and international bodies such as the European Union. The rules, regulations, policies and procedures affecting Discovery’s businesses are constantly subject to change. These descriptions are summary in nature and do not purport to describe all present and proposed laws and regulations affecting Discovery’s businesses.

 

 

The FCC’s Program Access Rules prevent a cable programming vendor in which a cable operator has an “attributable” ownership interest under FCC rules from entering into exclusive contracts for programming with a cable operator and from discriminating among competing Multi-Channel Video Programming Distributors (“MVPDs”) in the price, terms and conditions for the sale or delivery of programming. These rules also permit MVPDs to initiate complaints to the FCC against program suppliers if an MVPD is unable to obtain rights to programming on nondiscriminatory terms. The FCC recently voted to extend the Program Access Rules exclusivity ban for an additional five years, and has proposed other changes that would increase the rights of MVPDs. Discovery is currently subject to the Program Access Rules because: (a) Advance/Newhouse, which operates cable systems, holds an attributable interest in Discovery under the FCC’s rules on ownership interests; and (b) Mr. John Malone, who holds an attributable interest in Discovery through Discovery Holding Company, also holds an attributable interest in a company whose subsidiary operates a cable television system. Another company in which Mr. Malone holds an attributable interest and serves as Chairman of the Board, Liberty Media Corporation, has applied to acquire de facto control of DirecTV, a direct broadcast satellite provider. When de facto control of DirecTV was acquired by a subsidiary of News Corporation, the FCC imposed program access conditions on certain of the programming networks affiliated with News Corporation that are similar to the Program Access Rules, but also gave MVPDs the right to enter into commercial arbitration to resolve impasses over certain programming agreements relating to regional sports networks and the signals of local broadcast television stations owned and operated by News Corporation. In its application to acquire de facto control of DirecTV, Liberty Media stated that it would agree to be bound by the program access conditions previously imposed upon News Corporation. Whether the FCC will impose those conditions, other conditions, or additional conditions, and how Discovery will be affected, is not yet known.

 

 

The FCC has initiated proceedings inquiring about its authority to require MVPD programming to be provided to subscribers on an à la carte basis, which would require them to be sold as individual channels rather than as part of program tiers. It also has proposed that program vendors be required to sell programming to MVPDs on an unbundled basis, so that programming vendors like Discovery would be precluded from requiring MVPDs to take a basket of program channels. Members of Congress also have indicated an interest in enabling legislation to achieve these same goals.

 

The Cable Act of 1992 imposed “must carry” regulations on cable systems, requiring them to carry the signals of local broadcast television stations. The scope of the must carry rules has since been extended to direct broadcast satellite systems. The FCC recently adopted an order requiring most cable systems, following the anticipated end of analog television broadcasting in February 2009, to carry the digital signals of local television stations and to carry the same signal in an analog format. The FCC also has under consideration a proposal to require carriage by cable systems of additional program streams (“multicast programming”) transmitted by broadcast television stations. The FCC in November 2007 announced that it will require cable operators to provide independent programmers with leased capacity at rates below those now prevailing. In June 2007, the FCC released a notice of proposed rulemaking considering changes to its program carriage rules, which govern carriage disputes between programmers and distributors. Changes to these rules could affect the terms under which Discovery’s services are distributed

 

 

FCC rules limit the amount and content of commercial matter that may be shown on cable channels during programs designed for children 12 years of age or younger. Additionally, new rules, which became effective in 2007, restrict the ability of programmers to display website addresses during children’s programming unless those websites meet certain criteria designed to limit exposure to commercial matter. The FCC and other policymakers are examining other issues that could affect advertising during programming designed for children.

 

 

Discovery operates several internet websites which Discovery uses to distribute information about and supplement Discovery’s programs and to offer consumers the opportunity to purchase consumer products and services. Internet services are now subject to regulation in the United States relating to the privacy and security of personally identifiable user information and acquisition of personal information from children under 13, including the federal Child Online Protection Act (COPA) and the federal Controlling the Assault of Non-Solicited Pornography and Marketing Act (CAN-SPAM). In addition, a majority of states have enacted laws that impose data security and security breach obligations. Additional federal and state laws and regulations may be adopted with respect to the Internet or other online services, covering such issues as user privacy, child safety, data security, advertising, pricing, content, copyrights and trademarks, access by persons with disabilities, distribution, taxation and characteristics and quality of products and services. In addition, to the extent Discovery offers products and services to online consumers outside the United States, the laws and regulations of foreign jurisdictions, including, without limitation, consumer protection, privacy, advertising, data retention, intellectual property, and content limitations, may impose additional compliance obligations on Discovery.

 

COMPETITION

 

The entertainment and media services industry is highly competitive, with much of the competition centered in Los Angeles, California, the largest and most competitive market, particularly for domestic television and feature film production as well as for the management of content libraries. We expect that competition will increase as a result of industry consolidation and alliances, as well as from the emergence of new competitors. In particular, major motion picture studios such as Paramount Pictures, Sony Pictures Entertainment, Twentieth Century Fox, Universal Pictures, The Walt Disney Company and Warner Bros. Entertainment, while Ascent Media’s customers, can perform similar services in-house with substantially greater financial resources than Ascent Media’s, and in some cases significant marketing advantages. These studios may also outsource their requirements to other independent providers like us or to other studios. Other major competitors of Ascent Media include: Thomson, a French corporation, particularly under its Technicolor brand; Kodak, through its Laser Pacific division; Deluxe Entertainment Services; and DG FastChannel, Inc. Ascent Media also actively competes with certain industry participants that have a unique operating niche or specialty business. There is no assurance that Ascent Media will be able to compete effectively against these competitors. Ascent Media’s management believes that important competitive factors include the range of services offered, reputation for quality and innovation, pricing and long-term relationships with customers.

Cable and satellite network programming is a highly competitive business in the United States and worldwide. Discovery’s cable and satellite networks and websites generally compete for advertising revenue with other cable and broadcast television networks, online and mobile outlets, radio programming and print media. Discovery’s networks and websites also compete for their target audiences with all forms of programming and other media provided to viewers, including broadcast networks, local over-the-air television stations, competitors’ pay and basic cable television networks, pay-per-view and video-on-demand services, online activities and other forms of news, information and entertainment. Discovery’s networks also compete with other television networks for distribution and affiliate fees derived from distribution agreements with cable television operators, satellite operators and other distributors. The Discovery commerce and education division also operates in highly competitive industries with Discovery’s e-commerce and catalogue business competing with brick and mortar and online retailers and Discovery’s education business competing with other providers of educational products to schools, including providers with long-standing relationships, such as Scholastic.

 

EMPLOYEES

 

We currently have no corporate employees. Liberty provides us with certain management and administrative services pursuant to a services agreement, which includes the services of our executive officers some of whom remain executive officers of Liberty.

 

As of December 31, 2007, Ascent Media had approximately 3,900 employees, most of which worked on a full-time basis. Approximately 2,900 of Ascent Media’s employees were employed in the United States, with the remaining 1,000 employed outside the United States, principally in the United Kingdom and the Republic of Singapore. Approximately 450 of Ascent Media’s employees belong to either the International Alliance of Theatrical Stage Employees in the United States or the Broadcasting Entertainment Cinematograph and Theatre Union in the United Kingdom.

 

As of December 31, 2007, Discovery had approximately 3,600 employees. None of Discovery’s employees is subject to a collective bargaining agreement.

 

INTELLECTUAL PROPERTY

 

Discovery’s intellectual property assets principally include copyrights in television programming, websites and other content, trademarks in brands, names and logos, domain names and licenses of intellectual property rights of various kinds.

 

Discovery is fundamentally a content company and the protection of its brands and content are of primary importance. To protect Discovery’s intellectual property assets, Discovery relies upon a combination of copyright, trademark, unfair competition, trade secret and Internet/domain name statutes and laws and contract provisions. However, there can be no assurance of the degree to which these measures will be successful in any given case. Moreover, effective intellectual property protection may be either unavailable or limited in certain foreign territories. Policing unauthorized use of Discovery’s products and services and related intellectual property is often difficult and the steps taken may not always prevent the infringement by unauthorized third parties of Discovery’s intellectual property. Discovery seeks to limit that threat through a combination of approaches.

 

Third parties may challenge the validity or scope of Discovery’s intellectual property from time to time, and such challenges could result in the limitation or loss of intellectual property rights. Irrespective of their validity, such claims may result in substantial costs and diversion of resources which could have an adverse effect on Discovery’s operations. In addition, piracy, including in the digital environment, continues to present a threat to revenues from products and services based on intellectual property.

 

 

For financial information related to the geographic areas in which we do business, see note 18 to our consolidated financial statements found in Part II of this report.

 

All of our filings with the Securities and Exchange Commission (the “SEC”), including our Form 10-Ks, Form 10-Qs and Form 8-Ks, as well as amendments to such filings are available on our Internet website free of charge generally within 24 hours after we file such material with the SEC. Our website address is www.discoveryholdingcompany.com.

 

Our corporate governance guidelines, code of business conduct and ethics, compensation committee charter, and audit committee charter are available on our website. In addition, we will provide a copy of any of these documents, free of charge, to any shareholder who calls or submits a request in writing to Investor Relations, Discovery Holding Company, 12300 Liberty Boulevard, Englewood, Colorado 80112, Tel. No. (866) 876-0461.

 

The information contained on our website is not part of this Annual Report and is not incorporated by reference herein.

 

 

An investment in our common stock involves risk. You should carefully consider the risks described below, together with all of the other information included in this annual report in evaluating our company and our common stock. Any of the following risks, if realized, could have a material adverse effect on the value of our common stock.

 

 

We are a holding company, and we could be unable in the future to obtain cash in amounts sufficient to service our financial obligations or meet our other commitments.  Our ability to meet our financial obligations and other contractual commitments depends upon our ability to access cash. We are a holding company, and our sources of cash include our available cash balances, net cash from the operating activities of our subsidiaries, any dividends and interest we may receive from our investments, availability under any credit facilities that we may obtain in the future and proceeds from any asset sales we may undertake in the future. The ability of our operating subsidiaries to pay dividends or to make other payments or advances to us depends on their individual operating results and any statutory, regulatory or contractual restrictions to which they may be or may become subject.

 

We do not have access to the cash that Discovery generates from its operating activities.  Discovery generated approximately $242 million, $480 million and $69 million of cash from its operations during the years ended December 31, 2007, 2006 and 2005, respectively. Discovery uses the cash it generates from its operations to fund its investing activities and to service its debt and other financing obligations. We do not have access to the cash that Discovery generates unless Discovery makes a distribution with respect to its membership interests payable in cash, redeems any or all of its outstanding membership interests for cash or makes other payments or advances to its members. Prior to May 14, 2007, DCI did not pay any dividends on its capital stock, and since that date, Discovery has not made any distributions to its members, and instead has used all of its available cash in the expansion of its business and to service its debt obligations. Covenants in Discovery’s existing debt instruments also restrict the payment of dividends and cash distributions to members. We expect that Discovery will continue to apply its available cash to the expansion of its business. We do not currently have sufficient voting control to cause Discovery to make distributions, payments or advances to its members, or otherwise provide us access to Discovery’s cash.

 

We have limited operating history as a separate company upon which you can evaluate our performance.  We became a separate public company on July 21, 2005, the effective date of our spin off to Liberty’s shareholders. The historical financial information included in this annual report for periods prior to our existence may not necessarily be representative of our results as a separate company. There can be no assurance that our business strategy will be successful on a long-term basis. We may not be able to grow our businesses as planned and may not be profitable.

 

We do not have the right to manage Discovery, which means we cannot cause Discovery to operate in a manner that is favorable to us.  Discovery is managed by its members rather than a board of directors. Generally, all significant actions to be taken by Discovery require the approval of the holders of a majority of Discovery’s membership interests. However, pursuant to a Limited Liability Company Agreement, the taking of certain actions (including, among other things, a merger of Discovery, or the issuance of additional membership interests in Discovery or approval of annual business plans) requires the approval of the holders of at least 80% of Discovery’s

membership interests. Although our status as a 662/3% member of Discovery enables us to exercise influence over the management and policies of Discovery, such status does not enable us to cause any actions to be taken. Advance/Newhouse holds a 331/3% interest in Discovery, which ownership interest enables them to prevent Discovery from taking actions requiring 80% approval. Even if the proposed transaction with Advance/Newhouse is completed, the terms of the preferred stock they would receive is expected to provide them with similar blocking rights.

 

The liquidity and value of our interest in Discovery may be adversely affected by a Limited Liability Company Agreement to which we are a party.  Our 662/3% interest in Discovery is subject to the terms of a Limited Liability Company Agreement among the holders of Discovery membership interests. Among other things, the Limited Liability Company Agreement restricts our ability to directly sell or transfer our interest in Discovery or to borrow against its value. These restrictions impair the liquidity of our interest in Discovery.

 

We do not have the ability to require Advance/Newhouse to sell its interest in Discovery to us, nor does it have the ability to require us to sell our interest to Advance/Newhouse. We and Advance/Newhouse have announced our intention to effect a restructuring of our respective interests pursuant to which Discovery would be 100% owned by a new holding company. No assurance can be made that this transaction will be completed on the terms contemplated or at all. If the transaction is not completed, the current governance relationships affecting Discovery and our liquidity in Discovery may continue indefinitely.

 

Because we do not control the business management practices of Discovery, we rely on Discovery for the financial information that we use in accounting for our ownership interest in Discovery.  We account for our 662/3% membership interest in Discovery using the equity method of accounting and, accordingly, in our financial statements we record our share of Discovery’s net income or loss. Because we do not control Discovery’s decision-making process or business management practices, within the meaning of U.S. accounting rules, we rely on Discovery to provide us with financial information prepared in accordance with generally accepted accounting principles, which we use in the application of the equity method. We have entered into an agreement with Discovery regarding the use by us of certain information regarding Discovery in connection with our financial reporting and disclosure requirements as a public company. However, such agreement limits the public disclosure by us of certain non-public information regarding Discovery (other than specified historical financial information), and also restricts our ability to enforce the agreement against Discovery with a lawsuit seeking monetary damages, in the absence of gross negligence, reckless conduct or willful misconduct on the part of Discovery. In addition, we cannot change the way in which Discovery reports its financial results or require Discovery to change its internal controls over financial reporting.

 

We cannot be certain that we will be successful in integrating acquired businesses, if any.  Our businesses and those of our subsidiaries may grow through acquisitions in selected markets. Integration of new businesses may present significant challenges, including: realizing economies of scale in programming and network operations; eliminating duplicative overheads; and integrating networks, financial systems and operational systems. We or the applicable subsidiary cannot assure you that, with respect to any acquisition, we will realize anticipated benefits or successfully integrate any acquired business with our existing operations. In addition, while we intend to implement appropriate controls and procedures as we integrate acquired companies, we may not be able to certify as to the effectiveness of these companies’ disclosure controls and procedures or internal control over financial reporting (as required by U.S. federal securities laws and regulations) until we have fully integrated them.

 

Our businesses are subject to risks of adverse government regulation.  Programming services, satellite carriers, television stations and Internet and data transmission companies are subject to varying degrees of regulation in the United States by the Federal Communications Commission and other entities and in foreign countries by similar entities. Such regulation and legislation are subject to the political process and have been in constant flux over the past decade. Moreover, substantially every foreign country in which our subsidiaries or business affiliates have, or may in the future make, an investment regulates, in varying degrees, the distribution, content and ownership of programming services and foreign investment in programming companies. Further material changes in the law and regulatory requirements must be anticipated, and there can be no assurance that our business and the business of our affiliates will not be adversely affected by future legislation, new regulation or deregulation.

We have overlapping directors and management with Liberty and Liberty Global, Inc., which may lead to conflicting interests.  Five of our six executive officers also serve as executive officers of Liberty and one of our executive officers serves as an executive officer of Liberty Global, Inc., or LGI. LGI is an independent, publicly traded company, which was formed in connection with the business combination between UnitedGlobalCom, Inc. and Liberty Media International, Inc., or LMI. All of the shares of LMI were distributed by Liberty to its shareholders in June 2004. LGI is the largest international cable operator based on number of subscribers as of September 30, 2007. Our board of directors includes persons who are members of the board of directors of Liberty and/or LGI. We do not own any interest in Liberty or LGI, and to our knowledge Liberty and LGI do not own any interest in us. The executive officers and the members of our board of directors have fiduciary duties to our stockholders. Likewise, any such persons who serve in similar capacities at Liberty and/or LGI have fiduciary duties to such company’s stockholders. Therefore, such persons may have conflicts of interest or the appearance of conflicts of interest with respect to matters involving or affecting each company. For example, there may be the potential for a conflict of interest when we, Liberty or LGI look at acquisitions and other corporate opportunities that may be suitable for each of us. Moreover, most of our directors and officers continue to own Liberty and/or LGI stock and options to purchase Liberty and/or LGI stock. These ownership interests could create, or appear to create, potential conflicts of interest when these individuals are faced with decisions that could have different implications for our company and Liberty or LGI. From time to time, Liberty or LGI or their respective affiliates may enter into transactions with us or our subsidiaries or other affiliates, such as affiliation agreements relating to the distribution of Discovery’s international networks. Although the terms of any such transactions or agreements will be established based upon negotiations between employees of the companies involved, there can be no assurance that the terms of any such transactions will be as favorable to us or our subsidiaries or affiliates as would be the case where the parties are completely at arms’ length.

 

We and Liberty or LGI may compete for business opportunities.  Liberty and LGI each own interests in various U.S. and international programming companies that have subsidiaries or controlled affiliates that own or operate domestic or foreign programming services that may compete with the programming services offered by our businesses. LGI is also the largest cable operator outside the U.S. We have no rights in respect of U.S. or international programming opportunities developed by or presented to the subsidiaries or controlled affiliates of Liberty or LGI, and the pursuit of these opportunities by such subsidiaries or affiliates may adversely affect the interests of our company and its shareholders. We also have no special rights in respect to programming distribution on LGI’s cable systems outside the scope of an arms-length affiliation agreement. In addition, a subsidiary of LGI operates a playout facility that competes with Ascent Media’s London playout facility, and it is likely that other competitive situations will arise in the future. Because we, Liberty and LGI have some overlapping directors and officers, the pursuit of business opportunities may serve to intensify the conflicts of interest or appearance of conflicts of interest faced by our respective management teams. Our restated certificate of incorporation provides that no director or officer of ours will be liable to us or our stockholders for breach of any fiduciary duty by reason of the fact that any such individual directs a corporate opportunity to another person or entity (including LMI and LGI) instead of us, or does not refer or communicate information regarding such corporate opportunity to us, unless (x) such opportunity was expressly offered to such person solely in his or her capacity as a director or officer of our company or as a director or officer of any of our subsidiaries, and (y) such opportunity relates to a line of business in which our company or any of our subsidiaries is then directly engaged.

 

It may be difficult for a third party to acquire us, even if doing so may be beneficial to our shareholders.  Certain provisions of our restated certificate of incorporation and bylaws may discourage, delay or prevent a change in control of our company that a shareholder may consider favorable. These provisions include the following:

 

 

 

Our company has adopted a shareholder rights plan in order to encourage anyone seeking to acquire us to negotiate with our board of directors prior to attempting a takeover. While the plan is designed to guard against coercive or unfair tactics to gain control of us, the plan may have the effect of making more difficult or delaying any attempts by others to obtain control of us.

 

Holders of any single series of our common stock may not have any remedies if any action by our directors or officers has an adverse effect on only that series of our common stock.  Principles of Delaware law and the provisions of our restated certificate of incorporation may protect decisions of our board of directors that have a disparate impact upon holders of any single series of our common stock. Under Delaware law, the board of directors has a duty to act with due care and in the best interests of all of our shareholders, including the holders of all series of our common stock. Principles of Delaware law established in cases involving differing treatment of multiple classes or series of stock provide that a board of directors owes an equal duty to all common shareholders regardless of class or series and does not have separate or additional duties to any group of shareholders. As a result, in some circumstances, our directors may be required to make a decision that is adverse to the holders of one series of our common stock. Under the principles of Delaware law referred to above, you may not be able to challenge these decisions if our board of directors is disinterested and adequately informed with respect to these decisions and acts in good faith and in the honest belief that it is acting in the best interests of all of our shareholders.

 

 

A loss of any of Ascent Media’s large customers would reduce its revenue.  Although Ascent Media serviced over 3,800 customers during the year ended December 31, 2007, its ten largest customers accounted for approximately 47% of its consolidated revenue. The ten largest customers of the Creative Services group accounted for approximately 47% of the revenue of the Creative Services operating segment during the 2007 fiscal year. The ten largest customers of the Network Services group accounted for approximately 62% of the revenue of the Network Services operating segment during the 2007 fiscal year. The loss of, and failure to replace, any significant portion of the revenue generated from sales to any of Ascent Media’s largest customers could have a material adverse effect on the business of Ascent Media or on the affected operating segment. Creative Services group revenue generated by Ascent Media’s largest customers represent various types of services provided by various facilities within the Creative Services group for multiple points of contact at the corporate customer. Network origination services are generally provided pursuant to contracts, with terms of one to three years, or longer. Ascent Media’s ten largest customers include, among others, the parent companies of six major motion picture studios.

 

Discovery and its subsidiaries accounted for approximately 6% of Ascent Media’s consolidated revenue, including 15% of Network Services group revenue during 2007. Sales by Ascent Media to Discovery in 2007

consisted primarily of $7.3 million in systems integration projects and $34.5 million in content distribution. Ascent Media provides content distribution services to Discovery primarily in Asia and Europe pursuant to contracts that currently extend to 2010 and 2011, respectively.

 

Ascent Media’s business depends on certain client industries.  Ascent Media derives much of its revenue from services provided to the motion picture and television production industries and from the data transmission industry. Fundamental changes in the business practices of any of these client industries could cause a material reduction in demand by Ascent Media’s clients for the services offered by Ascent Media. Ascent Media’s business benefits from the volume of motion picture and television content being created and distributed as well as the success or popularity of an individual television show. Accordingly, a decrease in either the supply of, or demand for, original entertainment content would have a material adverse effect on Ascent Media’s results of operations. Because spending for television advertising drives the production of new television programming, as well as the production of television commercials and the sale of existing content libraries for syndication, a reduction in television advertising spending would adversely affect Ascent Media’s business. Factors that could impact television advertising and the general demand for original entertainment content include the growing use of personal video recorders and video-on-demand services, continued fragmentation of and competition for the attention of television audiences, and general economic conditions.

 

Because Ascent Media uses third-party satellite and terrestrial connectivity services to provide certain of its creative, media management and network services, a material disruption to such connectivity services could have a negative impact on Ascent Media’s operations.  Ascent Media obtains satellite transponder capacity, fiber-optic capacity and Internet connectivity pursuant to long-term contracts and other arrangements with third-party vendors. Such connectivity services are used in connection with many aspects of Ascent Media’s business, including network origination, teleport services, digital media management, dailies, live remote telecine services, distribution of advertising, syndicated television programming and other content, and various Web-based services and interfaces. Although Ascent Media believes that its arrangements with connectivity suppliers are adequate, disruptions in such services may occur from time to time as a result of technical malfunction, disputes with suppliers, force majeure or other causes. In the event of any such disruption in satellite or terrestrial connectivity service, Ascent Media may incur additional costs to supplement or replace the affected service, and may be required to compensate its own customers for any resulting declines in service levels.

 

A labor dispute in our client industries may disrupt Ascent Media’s business.  The cost of producing and distributing entertainment programming has increased substantially in recent years due to, among other things, the increasing demands of creative talent and industry-wide collective bargaining agreements.

 

A significant labor dispute in Ascent Media’s client industries could have a material adverse effect on its business. An industry-wide strike or other job action by or affecting the Writers Guild, Screen Actors Guild or other major entertainment industry union could reduce the supply of original entertainment content, which would in turn, reduce the demand for Ascent Media’s services. An extensive work stoppage would affect feature film production as well as episodic television and commercial production and could have a material adverse effect on the creative services group, including the potential loss of key personnel and the possibility that broadcast and cable networks will seek to reduce the proportion of their schedules devoted to scripted programming.

 

On November 5, 2007, Writers Guild of America, East and West (“Writers Guild”) declared a strike affecting the script writing for television shows and films. The strike has had a significant adverse effect on the revenue generated by Ascent Media’s creative services business for services provided on new entertainment projects utilizing scripted content and the production of new television commercials.

 

On February 10, 2008, the Writers Guild announced that its governing boards had voted to recommend the terms of a proposed new contract with the Alliance of Motion Picture and Television Producers (“AMPTP”) and suspended picketing by the Writers Guild against producers. Members of the Writers Guild voted to end the strike on February 12, 2008. Voting on ratification of the proposed contracts was expected to take place over the following several weeks. There can be no assurances that the proposed contract will be approved by the members of the Writers Guild and AMPTP, respectively. Failure to ratify the proposed contract could result in further strikes or job actions. Even if the contract is approved, the 2007-2008 television season has been significantly affected by the strike. Networks and producers are expected to resume production of some scripted television programming soon.

However, it is expected that some programming will not resume production this season, if at all. Accordingly, the full impact of the strike cannot currently be determined.

 

The existing contract between the Screen Actors Guild and AMPTP is currently scheduled to expire June 30, 2008.

 

Changes in technology may limit the competitiveness of and demand for Ascent Media’s services.  The post-production industry is characterized by technological change, evolving customer needs and emerging technical standards, and the data transmission industry is currently saturated with companies providing services similar to Ascent Media’s. Historically, Ascent Media has expended significant amounts of capital to obtain equipment using the latest technology. Obtaining access to any new technologies that may be developed in Ascent Media’s industries will require additional capital expenditures, which may be significant and may have to be incurred in advance of any revenue that may be generated by such new technologies. In addition, the use of some technologies may require third party licenses, which may not be available on commercially reasonable terms. Although we believe that Ascent Media will be able to continue to offer services based on the newest technologies, we cannot assure you that Ascent Media will be able to obtain any of these technologies, that Ascent Media will be able to effectively implement these technologies on a cost-effective or timely basis or that such technologies will not render obsolete Ascent Media’s role as a provider of motion picture and television production services. If Ascent Media’s competitors in the data transmission industry have technology that enables them to provide services that are more reliable, faster, less expensive, reach more customers or have other advantages over the data transmission services Ascent Media provides, then the demand for Ascent Media’s data transmission services may decrease.

 

While Ascent Media believes that its business methods and technical processes do not infringe upon the proprietary rights of any third parties, there can be no assurances that third parties will not assert infringement claims against Ascent Media.  Ascent Media’s business of providing Creative and Network services is highly dependent upon the technical abilities and knowledge of its personnel and business methods and processes developed by Ascent Media and its subsidiaries and their respective predecessors over time. There can be no assurance that third parties will not bring copyright, trademark infringement or other proprietary rights claims against Ascent Media, or claim that Ascent Media’s use of certain technologies violates a patent. There can be no assurances as to the outcome of any such claims. However, even if these claims are not meritorious, they could be costly and could divert management’s attention from other more productive activities. If it is determined that Ascent Media has infringed upon or misappropriated a third party’s proprietary rights, there can be no assurance that any necessary license or rights could be obtained on terms satisfactory to Ascent Media, if at all. The inability to obtain any such license or rights could result in the incurrence of expenses and changes in the way Ascent Media operates its business.

 

Loss of key personnel could negatively impact our business.  Our future success depends in large part on the retention, continued service and specific abilities of our key creative, technical and management personnel. A significant percentage of our revenues can be attributed to services that can only be performed by certain highly compensated, specialized employees, and in certain instances, our customers have identified by name those personnel requested to work on such customers’ projects. Competition for highly qualified employees in the entertainment and media services industry is intense and the process of locating and recruiting key creative, technical and management personnel with the combination of skills and abilities required to execute our strategy is time-consuming. We have employment agreements with many of our key creative, technical and management personnel. However, there can be no assurance that we will continue to attract, motivate and retain key personnel, and any inability to do so could negatively impact our business and our ability to grow.

 

Risk of loss from earthquakes or other catastrophic events could disrupt Ascent Media’s business.  Some of Ascent Media’s purpose-built facilities are located in Southern California, a region known for seismic activity. Due to the extensive amount of specialized equipment incorporated into the specially designed recording and scoring stages, editorial suites, mixing rooms and other post-production facilities, Ascent Media’s operations in this region may not be able to be temporarily relocated to mitigate the impacts of a catastrophic event. Ascent Media carries insurance for property loss and business interruption resulting from such events, including earthquake insurance, subject to deductibles, and has facilities in other geographic locations. Although we believe Ascent Media has adequate insurance coverage relating to damage to its property and the temporary disruption of its business from

casualties, and that it could provide services at other geographic locations, there can be no assurance that such insurance and other facilities would be sufficient to cover all of Ascent Media’s costs or damages or Ascent Media’s loss of income resulting from its inability to provide services in Southern California for an extended period of time.

 

Failure to obtain renewal of FCC licenses could disrupt Ascent Media’s business.  Ascent Media holds licenses, authorizations and registrations from the FCC required for the conduct of its network services business, including earth station and various classes of wireless licenses and an authorization to provide certain services. Most of the FCC licenses held by Ascent Media are for transmit/receive earth stations, which cannot be operated without individual licenses. The licenses for these stations are granted for a period of fifteen years and, while the FCC generally renews licenses for satellite earth stations routinely, there can be no assurance that Ascent Media’s licenses will be renewed at their expiration dates. Registration with the FCC, rather than licensing, is required for receiving transmissions from satellites from points within the United States. Ascent Media relies on third party licenses or authorizations when it transmits domestic satellite traffic through earth stations operated by third parties. Our failure, and the failure of third parties, to obtain renewals of such FCC licenses could disrupt the network services segment of Ascent Media and have a material adverse effect on Ascent Media. Further material changes in the law and regulatory requirements must be anticipated, and there can be no assurance that our businesses will not be adversely affected by future legislation, new regulation, deregulation or court decisions.

 

Ascent Media operates in an increasingly competitive market, and there is a risk that it may not be able to effectively compete with other providers in the future.  The entertainment and media services and programming businesses in which Ascent Media competes are highly competitive and service-oriented. Ascent Media has few long-term or exclusive service agreements with its creative services customers. Business generation in these markets is based primarily on the reputation of the provider’s creative talent and customer satisfaction with reliability, timeliness, quality and price. The major motion picture studios, which are Ascent Media’s customers, such as Paramount Pictures, Sony Pictures Entertainment, Twentieth Century Fox, Universal Pictures, The Walt Disney Company and Warner Bros. Entertainment, have the capability to perform similar services in-house. These studios also have substantially greater financial resources than Ascent Media’s, and in some cases significant marketing advantages. Thus, depending on the in-house capacity available to some of these studios, a studio may be not only a customer but also a competitor. There are also numerous independent providers of services similar to Ascent Media’s and we actively compete with certain industry participants that have a unique operating niche or specialty business. If there were a significant decline in the number of motion pictures or the amount of original television programming produced, or if the studios or Ascent Media’s other clients either established in-house post-production facilities or significantly expanded their in-house capabilities, Ascent Media’s operations could be materially and adversely affected.

 

 

Discovery’s success is dependent upon U.S. and foreign audience acceptance of its programming and other entertainment content which is difficult to predict.  The production and distribution of pay television programs and other entertainment content are inherently risky businesses because the revenue Discovery derives and its ability to distribute its content depend primarily on consumer tastes and preferences that change in often unpredictable ways. The success of Discovery’s businesses depends on its ability to consistently create and acquire content and programming that meets the changing preferences of viewers in general, viewers in special interest groups, viewers in specific demographic categories and viewers in various overseas marketplaces. The commercial success of its programming and other content also depends upon the quality and acceptance of competing programs and other content available in the applicable marketplace at the same time. Other factors, including the availability of alternative forms of entertainment and leisure time activities, general economic conditions, piracy, digital and on-demand distribution and growing competition for consumer discretionary spending may also affect the audience for its content. Audience sizes for its media networks are critical factors affecting both (i) the volume and pricing of advertising that Discovery receives, and (ii) the extent of distribution and the license fees Discovery receives under agreements with its distributors. Consequently, reduced public acceptance of its entertainment content may decrease its audience share and adversely affect all of its revenue streams.

 

The loss of Discovery’s affiliation agreements, or renewals with less advantageous terms, could cause its revenue to decline.  Because Discovery’s media networks are licensed on a wholesale basis to distributors such as cable and satellite operators which in turn distribute them to consumers, Discovery is dependent upon the maintenance of

affiliation agreements with these operators. These affiliation agreements generally provide for the level of carriage Discovery’s networks will receive, such as channel placement and programming package inclusion (widely distributed, broader programming packages compared to lesser distributed, specialized programming packages), and for payment of a license fee to Discovery based on the numbers of subscribers that receive its networks. These per-subscriber payments represent a significant portion of Discovery’s revenue. These affiliation agreements generally have a limited term which varies from market to market and from distributor to distributor, and there can be no assurance that these affiliation agreements will be renewed in the future, or renewed on terms that are as favorable to Discovery as those in effect today. A reduction in the license fees that Discovery receives per subscriber or in the number of subscribers for which Discovery is paid, including as a result of a loss or reduction in carriage for Discovery’s media networks, could adversely affect its distribution revenue. Such a loss or reduction in carriage could also decrease the potential audience for Discovery’s programs thereby adversely affecting its advertising revenue.

 

Consolidation among cable and satellite operators has given the largest operators considerable leverage in their relationship with programmers, including Discovery. The two largest U.S. cable television system operators provide service to approximately 35% of U.S. households receiving cable or satellite television service and the two largest satellite television operators provide service to an additional 26% of such households. Discovery currently has agreements in place with the major U.S. cable and satellite operators which expire at various times beginning in 2008 through 2014. In 2008, Discovery will enter negotiations to renew distribution agreements for carriage of its networks involving a substantial portion of its domestic subscribers. A failure to secure a renewal or a renewal on less favorable terms may have a material adverse effect on Discovery’s results of operations and financial position. In addition, many of the overseas markets in which Discovery distributes its networks also have a small number of dominant distributors. Continued consolidation within the industry could further reduce the number of distributors available to carry Discovery’s programming and increase the negotiating leverage of its distributors which could adversely affect Discovery’s revenue.

 

Discovery operates in increasingly competitive industries.  The entertainment and media programming industries in which Discovery operates are highly competitive. Discovery competes with other programming networks for advertising, distribution and viewers. Discovery also competes for viewers with other forms of media entertainment, such as home video, movies, periodicals and online and mobile activities. In particular, online websites and search engines have seen significant advertising growth, a portion of which is derived from traditional cable network and satellite advertisers. In addition, there has been consolidation in the media industry and Discovery’s competitors include market participants with interests in multiple media businesses which are often vertically integrated. Discovery’s online businesses compete for users and advertising in the enormously broad and diverse market of free internet-delivered services. Discovery’s commerce business competes against a wide range of competitive retailers selling similar products. Its educational video business competes with other providers of educational products to schools. Discovery’s ability to compete successfully depends on a number of factors, including its ability to consistently supply high quality and popular content, access its niche viewerships with appealing category-specific programming, adapt to new technologies and distribution platforms and achieve widespread distribution. There can be no assurance that Discovery will be able to compete successfully in the future against existing or new competitors, or that increasing competition will not have a material adverse effect on its business, financial condition or results of operations.

 

Discovery’s business is subject to risks of adverse laws and regulations, both domestic and foreign.  Programming services like Discovery’s, and the distributors of its services, including cable operators, satellite operators and Internet companies, are highly regulated by U.S. federal laws and regulations issued and administered by various federal agencies, including the FCC, as well as by state and local governments. The U.S. Congress and the FCC currently have under consideration, and may in the future adopt, new laws, regulations and policies regarding a wide variety of matters that could, directly or indirectly, affect the operations of Discovery’s U.S. media properties. For example, legislators and regulators continue to consider rules that would effectively require cable television operators to offer all programming on an à la carte basis (which would allow viewers to subscribe for individual networks rather a package of channels) and/or require programmers to sell channels to distributors on an à la carte basis. Certain cable television operators and other distributors have already introduced tiers, or more targeted channel packages, to their customers that may or may not include some or all of Discovery’s networks. The unbundling of program services at the retail and/or wholesale level could reduce distribution of certain of

Discovery’s program services, thereby leading to reduced viewership and increased marketing expenses, and could affect its ability to compete for or attract the same level of advertising dollars or distribution fees. If the number of channels occupied by leased access programmers expands, it could have an adverse effect on Discovery’s ability to obtain carriage for its programming. In addition, a recent decision by the FCC will effectively require cable operators, beginning February 2009 and lasting for at least three years, to carry the signals of “must carry” broadcast stations in both digital and analog format unless all subscribers of the cable operator’s system can view the digital signal on every television set connected to the system. Carrying these additional signals may result in less capacity for other programming services, such as Discovery’s networks, which could adversely affect Discovery’s revenue.

 

Similarly, the foreign jurisdictions in which Discovery’s networks are offered have, in varying degrees, laws and regulations governing Discovery’s businesses. Programming businesses are subject to regulation on a country by country basis. Such regulations include à la carte pricing, license requirements, local programming quotas, limits on the amounts and kinds of advertising that can be carried, and requirements to make programming available on non-discriminatory terms, and can increase the cost of doing business internationally. Changes in regulations imposed by foreign governments could also adversely affect Discovery’s business, results of operations and ability to expand its operations beyond their current scope.

 

Macroeconomic risks associated with Discovery’s business could adversely affect its financial condition.  The current economic downturn in the United States and in other regions of the world in which Discovery operates could adversely affect demand for any of its businesses, thus reducing its revenue and earnings. For example, expenditures by advertisers are sensitive to economic conditions and tend to decline in recessionary periods and other periods of uncertainty. Because Discovery derives a substantial portion of its revenue from the sale of advertising, a decline or delay in advertising expenditures could reduce advertising prices and volume and result in a decrease in its revenue. The decline in economic conditions could also impact consumer discretionary spending. Such a reduction in consumer spending may impact pay television subscriptions, particularly to the more expensive digital service tiers, which could lead to a decrease in Discovery’s distribution fees.

 

Increased programming production and content costs may adversely affect Discovery’s results of operations and financial condition.  One of the most significant areas of expense for Discovery is for the licensing and production of content. In connection with creating original content, Discovery incurs production costs associated with, among other things, acquiring new show concepts and retaining creative talent, including actors, writers and producers. Discovery also incurs higher production costs when filming in HD than standard definition. The costs of producing programming have generally increased in recent years. These costs may continue to increase in the future, which may adversely affect Discovery’s results of operations and financial condition.

 

Disruption or failure of satellites and facilities on which Discovery depends to distribute its programming could adversely affect its business.  Discovery depends on satellite systems to transmit its media networks to cable television operators and other distributors worldwide. The distribution facilities include uplinks, communications satellites and downlinks. Even with back-up and redundant systems, transmissions may be disrupted as a result of local disasters that impair on-ground uplinks or downlinks, or as a result of an impairment of a satellite. Currently, there are a limited number of communications satellites available for the transmission of programming. If a disruption or failure occurs, Discovery may not be able to secure alternate distribution facilities in a timely manner, which could have a material adverse effect on its business and results of operations.

 

Discovery cannot be certain that it will realize anticipated benefits from any business acquisition that it effects.  Discovery may seek to grow through acquisitions in select markets, both within and outside its traditional lines of business. Acquisitions involve risks and significant challenges, including: realizing economies of scale; eliminating duplicative overhead; integrating networks, financial systems and operating systems; diverting the resources of management; incurring debt (which may be substantial) in financing such acquisitions; and addressing unanticipated problems and liabilities. In addition, while Discovery intends to implement appropriate controls and procedures as it integrates acquired companies, Discovery may not be able to certify as to the effectiveness of these companies’ disclosure controls and procedures or internal control over financial reporting (as required by U.S. federal securities laws and regulations) until it has fully integrated those acquired businesses.

 

Discovery must respond to and capitalize on rapid changes in new technologies and distribution platforms, including their effect on consumer behavior, in order to remain competitive and exploit new opportunities.  Technology in the video, telecommunications and data services industry is changing rapidly. Discovery must adapt

to advances in technologies, distribution outlets and content transfer and storage (whether legal or illegal) to ensure that its content remains desirable and widely available to its audiences while protecting its intellectual property interests. Discovery may not have the right, and may not be able to secure the right, to distribute some of its licensed content across these, or any other, new platforms and must adapt accordingly. The ability to anticipate and take advantage of new and future sources of revenue from these technological developments will affect Discovery’s ability to expand its business and increase revenue.

 

Similarly, Discovery also must adapt to changing consumer behavior driven by technological advances such as video-on-demand and a desire for more user-generated and interactive content. Devices that allow consumers to view Discovery’s entertainment content from remote locations or on a time-delayed basis and technologies which enable users to fast-forward or skip advertisements may cause changes in audience behavior that could affect the attractiveness of Discovery’s offerings to advertisers and could therefore adversely affect its revenues. If Discovery cannot ensure that its content is responsive to the lifestyles of its target audiences and capitalize on technological advances, there could be a negative effect on its business.

 

Discovery’s revenue and operating results are subject to seasonal and cyclical variations.  Discovery’s business has experienced and is expected to continue to experience some seasonality due to, among other things, seasonal advertising patterns, seasonal influences on people’s viewing habits, and a heavy concentration of sales in its commerce business during the fourth quarter. For example, due to increased demand in the spring and holiday seasons, the second and fourth quarters normally have higher advertising revenue than the first and third quarters. In addition, advertising revenue in even-numbered years benefit from political advertising. If a short-term negative impact on our business were to occur during a time of high seasonal demand, there could be a disproportionate effect on the operating results of Discovery’s business for the year.

 

Discovery continues to develop new products and services for evolving markets. There can be no assurance of the success of these efforts due to a number of factors, some of which are beyond Discovery’s control.  There are substantial uncertainties associated with Discovery’s efforts to develop new products and services for evolving markets, and substantial investments may be required. Initial timetables for the introduction and development of new products and services may not be achieved, and price and profitability targets may not prove feasible. External factors, such as the development of competitive alternatives, rapid technological change, regulatory changes and shifting market preferences, may cause new markets to move in unanticipated directions.

 

Risks associated with Discovery’s international operations could harm its financial condition.  Discovery’s networks are offered worldwide. Inherent economic risks of doing business in international markets include, among other things, longer payment cycles, foreign taxation and currency exchange risk. As Discovery expands the provision of its products and services to overseas markets, we cannot assure you whether these risks and uncertainties will harm Discovery’s results of operations.

 

Discovery’s international operations may also be adversely affected by export and import restrictions, other trade barriers and acts of disruptions of services or loss of property or equipment that are critical to overseas businesses due to expropriation, nationalization, war, insurrection, terrorism or general social or political unrest or other hostilities.

 

The loss of key talent could disrupt Discovery’s business and adversely affect its revenue.  Discovery’s business depends upon the continued efforts, abilities and expertise of its corporate and divisional executive teams and entertainment personalities. Discovery employs or contracts with entertainment personalities who may have loyal audiences. These individuals are important to audience endorsement of its programs and other content. There can be no assurance that these individuals will remain with Discovery or retain their current audiences. If Discovery fails to retain these individuals or if Discovery’s entertainment personalities lose their current audience base, Discovery’s revenue could be adversely affected.

 

Piracy of Discovery’s entertainment content, including digital piracy, may decrease revenue received from its programming and adversely affect its business and profitability.  The success of Discovery’s business depends in part on its ability to maintain the intellectual property rights to its entertainment content. Discovery is fundamentally a content company and piracy of its brands, DVDs, cable television and other programming, digital content and other intellectual property has the potential to significantly affect the company. Piracy is particularly prevalent in many parts of the world that lack copyright and other protections similar to existing law in the U.S. It is also made easier by technological advances allowing the conversion of programming into digital formats, which facilitates the creation, transmission and

sharing of high quality unauthorized copies. Unauthorized distribution of copyrighted material over the Internet is a threat to copyright owners’ ability to protect and exploit their property. The proliferation of unauthorized use of Discovery’s entertainment content may have an adverse effect on its business and profitability because it reduces the revenue that Discovery potentially could receive from the legitimate sale and distribution of its content.

 

Financial market conditions may impede access to or increase the cost of financing Discovery’s operations and investments.  The recent changes in U.S. and global financial and equity markets, including market disruptions and tightening of the credit markets, may make it more difficult for Discovery to obtain financing for its operations or investments or increase the cost of obtaining financing. In addition, Discovery’s borrowing costs can be affected by short and long-term debt ratings assigned by independent rating agencies which are based, in significant part, on its performance as measured by credit metrics such as interest coverage and leverage ratios. A decrease in these ratings could increase Discovery’s cost of borrowing or make it more difficult for Discovery to obtain financing.

 

 

None

 

 

We share our executive offices in Englewood, Colorado under a services agreement with Liberty. All of our other real or personal property is owned or leased by our subsidiaries or affiliates.

 

Ascent Media’s operations are conducted at approximately 60 properties. Certain of these facilities are used by multiple operations within Ascent Media. In the United States, Ascent Media utilizes owned and leased properties in California, Connecticut, Florida, Georgia, New Jersey, New York and Virginia; the network services group also operates a satellite earth station and related facilities in Minnesota. Internationally, Ascent Media utilizes owned and leased properties in London, England. In addition, the creative services group operates a leased facility in Mexico City, Mexico, and the network services group operates two leased facilities in Singapore. Worldwide, Ascent Media leases approximately 1.4 million square feet and owns another 325,000 square feet. In the United States, Ascent Media’s leased properties total approximately 1.1 million square feet and have terms expiring between March 2008 and January 2018. Several of these agreements have extension options. The leased properties are used for our technical operations, office space and media storage. Ascent Media’s international leases have terms that expire between June 2008 and September 2020, and are also used for technical operations, office space and media storage. Over half of the international leases have extension clauses. Approximately 250,000 square feet of Ascent Media’s owned properties are located in Southern California, with another 45,000 square feet located in Northvale, New Jersey, Tappan, New York, Minneapolis, Minnesota and Stamford, Connecticut. In addition, Ascent Media owns approximately 30,000 square feet in London, England. Nearly all of Ascent Media’s owned properties are purpose-built for its technical and creative service operations. Ascent Media’s facilities are adequate to support its current near term growth needs.

 

Discovery owns its world headquarters located at One Discovery Place, Silver Spring, Maryland, where Discovery uses approximately 543,000 square feet for its executive offices. Discovery manages the distribution of its domestic network television programming through an approximately 53,000 square foot origination facility that it owns in Sterling, Virginia. Discovery also leases the following facilities for certain of its operating divisions: (i) approximately 151,000 square feet of office space at 850 Third Avenue, New York, New York and (ii) approximately 148,000 square feet of office space at 8045 Kennett Street, Silver Spring, Maryland.

 

Discovery also leases other office, studio and transmission facilities in the United States and several other countries for its businesses. Discovery considers its properties adequate for its present needs.

 

 

The registrant and its subsidiaries are not a party to any material legal proceedings.

 

 

None.

 

 

Market Information

 

We have two series of common stock, Series A and Series B, which trade on the Nasdaq Global Select Market under the symbols DISCA and DISCB, respectively. The following table sets forth the range of high and low sales prices of shares of our Series A and Series B common stock for the years ended December 31, 2007 and 2006.

 

 

Holders

 

As of January 31, 2008, there were approximately 3,000 and 100 record holders of our Series A common stock and Series B common stock, respectively (which amounts do not include the number of shareholders whose shares are held of record by banks, brokerage houses or other institutions, but include each institution as one shareholder).

 

Dividends

 

We have not paid any cash dividends on our Series A common stock and Series B common stock, and we have no present intention of so doing. Payment of cash dividends, if any, in the future will be determined by our Board of Directors in light of our earnings, financial condition and other relevant considerations.

Stock Performance Graph

 

The following graph sets forth the performance of our Series A common stock and our Series B common stock for the period beginning July 21, 2005 and ended December 31, 2007 as compared to the S&P Media Index and the Nasdaq Stock Market Index. The graph assumes $100 originally invested on July 21, 2005 and that all subsequent dividends were reinvested in additional shares.

 

 

 

Effective July 21, 2005, Liberty Media Corporation (“Liberty”) completed a spin off transaction pursuant to which our capital stock was distributed as a dividend to holders of Liberty’s Series A and Series B common stock. Subsequent to the spin off, we are a separate publicly traded company and we and Liberty operate independently. The spin off has been accounted for at historical cost due to the pro rata nature of the distribution. Accordingly, our historical financial statements are presented in a manner similar to a pooling of interest. The spin off did not involve the payment of any consideration by the holders of Liberty common stock and was intended to qualify as a tax-free spin off.

 

The following tables present selected historical information relating to our financial condition and results of operations for the past five years. The following data should be read in conjunction with our consolidated financial statements.

 

 

 

 

 

 

The following discussion and analysis provides information concerning our results of operations and financial condition. This discussion should be read in conjunction with our accompanying consolidated financial statements and the notes thereto.

 

Overview

 

We are a holding company and our businesses and assets include consolidated subsidiaries Ascent Media Group, LLC (“Ascent Media”) and Ascent Media CANS, LLC (dba AccentHealth) (“AccentHealth”), and a 662/3% ownership interest in Discovery Communications Holding, LLC. (“Discovery”), which we account for using the equity method of accounting. Accordingly, as described below, Discovery’s revenue is not reflected in the revenue we report in our financial statements.

 

Ascent Media provides creative and network services to the media and entertainment industries in the United States, the United Kingdom (“UK”) and Singapore. Ascent Media’s clients include major motion picture studios, independent producers, broadcast networks, programming networks, advertising agencies and other companies that produce, own and/or distribute entertainment, news, sports, corporate, educational, industrial and advertising content. Ascent Media’s operations are organized into the following three groups: creative services, network services and corporate and other.

 

In 2008, Ascent Media will continue to focus on leveraging its broad array of traditional media and file-based services to market itself as a full service provider to new and existing customers within the feature film, television production and advertising industries. Ascent Media’s strategy will focus on providing a unified portfolio of business-to-business services to enable media companies to realize the increasing benefits of digital distribution. With facilities in the U.S., the U.K. and Singapore, Ascent Media hopes to increase its services to multinational companies on a worldwide basis. The challenges that Ascent Media faces include continued development of end to end file-based solutions, increased competition in both its creative and network services, differentiation of its products and services to help maintain or increase operating margins and financing capital expenditures for equipment and other items to meet customers’ requirements for integrated and file-based workflows.

 

Our most significant asset is our interest in Discovery, which we do not control. During the second quarter of 2007, each of the shareholders of Discovery Communications, Inc. (“DCI”) contributed its DCI common stock to a newly formed company, Discovery, in exchange for Discovery membership interests. Subsequent to this contribution, each of the members of Discovery held the same ownership interests in Discovery as they previously held in DCI. DCI became a wholly-owned subsidiary of Discovery, and Discovery is the successor reporting entity of DCI.

Discovery is a leading global media and entertainment company that provides original and purchased programming across multiple distribution platforms in the United States and more than 170 other countries. Discovery also develops and sells consumer and educational products and services in the United States and internationally, and owns and operates a diversified portfolio of website properties and other digital services. Our share of the results of operations of Discovery is reflected in our consolidated results as earnings or losses of Discovery. To assist the reader in better understanding and analyzing our business, we have included a separate discussion and analysis of Discovery’s results of operations and financial condition below.

 

On May 14, 2007, Discovery and Cox Communications Holdings, Inc. (“Cox”) completed an exchange of Cox’s 25% ownership interest in Discovery for all of the capital stock of a subsidiary of Discovery that held Travel Channel, travelchannel.com and approximately $1.3 billion in cash (the “Cox Transaction”). Discovery raised the cash component through additional debt financing, and retired the membership interest previously owned by Cox. Upon completion of this transaction, we own a 662/3% interest in Discovery and Advance/Newhouse Programming Partnership (“Advance/Newhouse”) owns a 331/3% interest. We continue to account for our investment in Discovery using the equity method of accounting due to governance rights possessed by Advance/Newhouse which restrict our ability to control Discovery.

 

In December 2007, we announced that we had signed a non-binding letter of intent with Advance/Newhouse to combine our respective stakes in Discovery. As currently contemplated by the non-binding letter of intent, the transaction, if completed, would involve the following steps:

 

 

Although no assurance can be given, consummation of this transaction (the “Newhouse Transaction and Ascent Spin Off”) is expected to close in the second quarter of 2008 and would result in the consolidation of the results of Discovery within New DHC.

 

Acquisitions

 

Effective January 27, 2006, we acquired substantially all of the assets of AccentHealth’s healthcare media business for cash consideration of $46,793,000. AccentHealth operates an advertising-supported captive audience television network in doctor office waiting rooms nationwide. For financial reporting purposes, the acquisition is deemed to have occurred on February 1, 2006, and the results of operations of AccentHealth have been included in our consolidated results as part of the network services group since the date of acquisition.

 

Operating Cash Flow

 

We evaluate the performance of our operating segments based on financial measures such as revenue and operating cash flow. We define operating cash flow as revenue less cost of services and selling, general and administrative expense (excluding stock and other equity-based compensation and accretion expense on asset retirement obligations). We believe this is an important indicator of the operational strength and performance of our businesses, including the ability to invest in ongoing capital expenditures and service any debt. In addition, this measure allows management to view operating results and perform analytical comparisons and identify strategies to improve performance. This measure of performance excludes depreciation and amortization, stock and other equity-based compensation, accretion expense on asset retirement obligations, restructuring and impairment

charges that are included in the measurement of operating income pursuant to U.S. generally accepted accounting principles, or GAAP. Accordingly, operating cash flow should be considered in addition to, but not as a substitute for, operating income, cash flow provided by operating activities and other measures of financial performance prepared in accordance with GAAP. See note 18 to the accompanying consolidated financial statements for a reconciliation of operating cash flow to earnings (loss) before income taxes.

 

Results of Operations

 

Our consolidated results of operations include 100% of Ascent Media’s and AccentHealth’s results of operations, general and administrative expenses incurred at the DHC corporate level, and our share of earnings of Discovery.

 

Ascent Media’s creative services group generates revenue primarily from fees for video and audio post production, special effects and editorial services for the television, feature film and advertising industries. Generally, these services pertain to the completion of feature films, television programs and advertisements. These projects normally span from a few days to three months or more in length, and fees for these projects typically range from $10,000 to $1,000,000 per project. Additionally, the creative services group provides owners of film libraries a broad range of restoration, preservation, archiving, professional mastering and duplication services. The scope of these creative services vary in duration from one day to several months depending on the nature of the service, and fees typically range from less than $1,000 to $100,000 per project. The creative services group includes Ascent Media’s digital media distribution center, which provides file-based services in areas such as digital imaging, digital vault, distribution services and interactive media to new and existing distribution platforms.

 

The network services group’s revenue consists of fees relating to facilities and services necessary to assemble and transport programming for cable and broadcast networks across the world via fiber, satellite and the Internet. The group’s refvenue is also driven by systems integration and field support services, technology consulting services, design and implementation of advanced video systems, engineering project management, technical help desk and field service. This operating segment also includes the operations of AccentHealth. Approximately 55% of the network services group’s revenue relates to broadcast services, satellite operations and fiber services that are earned monthly under long-term contracts ranging generally from one to seven years. Additionally, approximately 45% of revenue relates to systems integration and engineering services that are provided on a project basis over terms generally ranging from three to twelve months.

 

Corporate related items and expenses are reflected in Corporate and other, below. Cost of services and operating expenses consists primarily of production wages, facility costs and other direct costs and selling, general and administrative expenses.

 

Our consolidated results of operations for the year ended December 31, 2006 include approximately eleven months of results for AccentHealth.

 

Revenue.  Our total revenue increased 2.8% and decreased 0.9% for the years ended December 31, 2007 and 2006, respectively, as compared to the corresponding prior year. In 2007, creative services group revenue increased $2,628,000 due to (i) an increase of $6,117,000 in commercial revenue driven primarily by strong worldwide demand in the first quarter, (ii) an increase of $3,042,000 in media services driven by growth in file-based digital vaulting and digital distribution services, offset by lower traditional lab and DVD services and (iii) favorable changes in foreign currency exchange rates of $6,284,000. These increases were partially offset by an $8,141,000 decrease in television post production services in the U.S. and U.K. and lower feature sound revenue of $4,163,000 driven by smaller feature sound projects and the shut down of certain audio facilities. In addition, creative services revenue was negatively impacted by the Writers Guild of America strike that primarily impacted television production in the fourth quarter of 2007. Network services group’s 2007 revenue increased $16,499,000 due to (i) an increase of $16,377,000 in system integration services revenue due to an increase in the number of projects, (ii) an increase of $5,175,000 in content distribution revenue in the U.S. and Singapore, (iii) an increase of $5,492,000 driven by AccentHealth due mainly to growth in advertising rates and (vi) favorable changes in foreign currency exchange rates of $4,519,000. These increases in revenue were partially offset by (i) a decrease of $10,500,000 primarily due to the expiration of certain distribution contracts in the U.K. which were not renewed and (ii) a decrease of $4,352,000 due to a one-time project in 2006.

 

In 2006, creative services group revenue decreased $3,921,000 as a result of (i) an $8,400,000 decline in media services due to lower traditional media and DVD services from major studios partially offset by continued growth in new digital services and (ii) lower television revenue of $2,165,000 driven by declines in the U.K. broadcast work, partially offset by higher television audio and post production services in the U.S. These creative services revenue decreases were partially offset by a $6,535,000 increase in commercial services, driven primarily by strong U.S. demand, and higher feature revenue of $1,770,000, driven by an increased number of titles for post production services, partially offset by smaller size feature sound projects and lower home theatre revenue. Network services group’s 2006 revenue decreased $2,501,000 as a result of (i) a decline in systems integration and services revenue of $11,080,000, reflecting significant one-time projects in 2005 and (ii) lower revenue in the U.K. of $15,060,000, primarily as a result of termination of content distribution contracts. These network services revenue decreases were partially offset by the acquisition of AccentHealth in 2006, which generated $20,873,000 of revenue, and by increased content distribution activity in the U.S. and Singapore.

 

Cost of Services.  Our cost of services increased $22,977,000 or 4.9% and $7,252,000 or 1.6% for the years ended December 31, 2007 and 2006, respectively, as compared to the corresponding prior year. A significant portion of the 2007 increase was across network services resulting from higher volumes of system integration services which have a higher percentage of equipment and labor costs. Creative services was slightly higher driven by revenue increases in commercial, features and new digital services. Additionally, changes in foreign currency exchange rates resulted in an increase of $7,220,000. In 2006, the increase in cost of services is driven by the AccentHealth acquisition which contributed costs of $6,439,000 and by changes in foreign currency exchange rates of $1,367,000.

 

As a percent of revenue, cost of services was 69.4%, 68.0% and 66.3% for the years ended December 31, 2007, 2006 and 2005, respectively. The increase in cost of services as a percent of revenue is driven by the higher system integration services revenue which has lower margins. Additionally, in each year, labor costs have increased as the revenue mix moves toward more labor intensive feature services and as projects have become increasingly more integrated, with complex work flows requiring higher levels of production labor and project management.

 

Selling, General and Administrative.  Our selling, general and administrative expenses (“SG&A”), including corporate expenses of both DHC and Ascent Media but excluding stock-based compensation and accretion expense on asset retirement obligations, decreased 7.5% and increased 4.0% for the years ended December 31, 2007 and 2006, respectively, as compared to the corresponding prior year. For 2007, the decline is driven by lower personnel costs, resulting from Ascent Media’s restructuring in the third and fourth quarters of 2006, and lower professional fees. For 2006, the acquisition of AccentHealth added $6,565,000 of SG&A expense, slightly offset by lower personnel costs and professional fees. As a percent of revenue, SG&A was 21.1%, 23.4% and 22.3% for the years ended December 31, 2007, 2006 and 2005, respectively.

Restructuring Charges.  During 2007, Ascent Media recorded restructuring charges of $761,000 related to severance in conjunction with ongoing restructuring efforts primarily within the U.K. creative services business. During 2006, Ascent Media recorded restructuring charges of $12,092,000 primarily related to severance from the realignment of its operating divisions. These restructuring activities were primarily in the Corporate and other group in the United States and United Kingdom. During 2005, Ascent Media recorded a restructuring charge of $4,112,000 related to the consolidation of certain operating facilities resulting in excess leased space, consolidation expenses and severance from reductions in headcount.

 

Depreciation and Amortization.  The decrease in depreciation and amortization expense for both 2007 and 2006 is due to assets becoming fully depreciated partially offset by new assets placed in service and for 2006, the AccentHealth acquisition.

 

Stock Compensation.  Stock-based compensation was $1,129,000, $1,817,000 and $4,383,000 for the years ended December 31, 2007, 2006 and 2005, respectively, and is included in SG&A in our consolidated statements of operations. Effective January 1, 2006, we adopted Statement No. 123R. Statement No. 123R requires that we amortize the grant date fair value of our stock option and SAR Awards that qualify as equity awards as stock compensation expense over the vesting period of such Awards. Statement No. 123R also requires that we record our liability awards at fair value each reporting period and that the change in fair value be reflected as stock compensation expense in our consolidated statement of operations. Prior to adoption of Statement No. 123R, the amount of expense associated with stock-based compensation was generally based on the vesting of the related stock options and stock appreciation rights and the market price of the underlying common stock. The expense reflected in our consolidated financial statements was based on the market price of the underlying common stock as of the date of the financial statements.

 

In 2001, Ascent Media granted to certain of its officers and employees stock options (the “Ascent Media Options”) with exercise prices that were less than the market price of Ascent Media common stock on the date of grant. The Ascent Media Options became exercisable for Liberty shares in connection with Liberty’s acquisition in 2003 of the Ascent Media shares that it did not already own. Prior to January 1, 2006, we amortized the “in-the-money” value of these options over the 5-year vesting period. Certain Ascent Media employees also hold options and stock appreciation rights granted by companies acquired by Ascent Media in the past several years and exchanged for Liberty options and SARs. Prior to January 1, 2006 we recorded compensation expense for the SARs based on the underlying stock price and vesting of such awards.

 

Effective August 3, 2006, Ascent Media adopted its 2006 Long-Term Incentive Plan (the “2006 Plan”). The 2006 Plan provides the terms and conditions for the grant of, and payment with respect to, Phantom Appreciation Rights (“PARs”) granted to certain officers and other key personnel of Ascent Media. The maximum number of PARs that may be granted under the 2006 Plan is 500,000, and there were 438,500 PARs granted as of December 31, 2007. Ascent Media recorded 2006 Plan expense of $276,000 for the year ended December 31, 2007, with no 2006 Plan expense recorded in 2006.

 

On July 21, 2005, Liberty completed the spin off of our capital stock. As a result of the 2005 Spin Off and related adjustments to Liberty’s stock incentive awards, options to acquire an aggregate of approximately 2.0 million shares of our Series A common stock and 3.0 million shares of our Series B common stock were issued to employees of Liberty. In addition, employees of Ascent Media who held stock options or stock appreciation rights (“SARs”) to acquire shares of Liberty common stock prior to the 2005 Spin Off continue to hold such options. SAR expense was a credit of $14,000 and an expense of $21,000 for the years ended December 31, 2007 and 2006, respectively. Pursuant to a reorganization agreement we entered into with Liberty in connection with the 2005 Spin Off, we are responsible for all stock options related to DHC common stock, and Liberty is responsible for all incentive awards related to Liberty common stock. We record stock-based compensation for all stock incentive awards held by our employees and our subsidiaries’ employees. Stock-based compensation expense was $867,000 and $1,796,000 for the years ended December 31, 2007 and 2006, respectively.

 

On May 24, 2005, Liberty commenced an offer to purchase certain stock options and SARs held by eligible employees of Ascent Media. The offer to purchase related to 1,173,028 options and SARs, and the aggregate offering price for such options and SARs was approximately $2.15 million. The offer to purchase expired on

June 21, 2005. Eligible employees tendered options with respect to 1,121,673 shares of Liberty Series A common stock, and Liberty purchased such options for aggregate cash payments of approximately $2.14 million. In connection with these purchases, Ascent Media recorded 2005 compensation expense of $3,830,000, which included (1) the amount of the cash payments less any previously accrued compensation for the SARs, (2) the previously unamortized in-the-money value related to the Ascent Media Options and (3) ongoing amortization of the unexercised Ascent Media options.

 

As of December 31, 2007, the total compensation cost related to unvested equity awards was approximately $540,000. Such amount will be recognized in our consolidated statements of operations over a weighted average period of approximately 1.2 years.

 

Impairment of Goodwill.  In connection with our 2007 annual evaluation of the recoverability of our goodwill, we estimated the value of our reporting units using a discounted cash flow analysis. The result of this valuation indicated that the fair value of the network services reporting unit was less than its carrying value. The network services reporting unit fair value was then used to calculate an implied value of the goodwill related to this reporting unit. The $165,347,000 excess of the carrying amount of the network services goodwill over its implied value was recorded as an impairment charge in the fourth quarter of 2007. The impairment charge is the result of lower future expectations for network services operating cash flow due to a continued decline in operating cash flow margins as a percent of revenue, resulting from competitive conditions in the entertainment and media services industries and increasingly complex customer requirements that are expected to continue for the foreseeable future.

 

As a result of the 2006 Restructuring and the declining financial performance of the former media management services group, including ongoing operating losses driven by technology and customer requirement changes in the industry, the former media management services group was tested for goodwill impairment in the third quarter of 2006, prior to our annual goodwill valuation assessment of the entire company. We estimated the fair value of that reporting unit principally by using trading multiples of revenue and operating cash flows of similar companies in the industry. This test resulted in a goodwill impairment loss for the former media management services group of $93,402,000, which represents the excess of the carrying value over the implied fair value of such goodwill.

 

Share of Earnings of Discovery.  From January 1, 2005 through May 14, 2007, we recorded our 50% share of the earnings of DCI. Subsequent to May 14, 2007, we recorded our 662/3% share of the earnings of Discovery. Our share of earnings of Discovery increased $38,193,000 and $23,778,000 for the years ended December 31, 2007 and 2006, respectively, as compared to the corresponding prior year periods. The 2007 increase resulted from our $89,781,000 share of Discovery’s gain on the Cox Transaction, along with an $8,340,000 increase as the result of our ownership interest in Discovery increasing from 50% to 662/3%. These increases were partially offset by Discovery incurring higher long-term incentive plan expenses and higher interest expense resulting from the debt incurred by Discovery in connection with the Cox Transaction. The 2006 increase is due to Discovery’s higher operating income partially offset by higher interest expense and the change in minority interests in consolidated subsidiaries.

 

For a more detailed discussion of Discovery’s results of operations, see “— Management’s Discussion and Analysis of Financial Condition and Results of Operations of Discovery.”

 

Income Taxes.  Our effective tax rate for the year ended December 31, 2007 was not meaningful because we recorded income tax expense of $59,157,000, but had a loss before taxes of $9,235,000. The pre-tax loss resulted primarily from a $165,347,000 goodwill impairment charge recorded in the fourth quarter of 2007, for which we receive no tax benefit. For the year ended December 31, 2006, the effective tax rate was not meaningful because we recorded income tax expense of $43,942,000, but had a loss before taxes of $2,068,000. The pre-tax loss resulted primarily from a $93,402,000 goodwill impairment charge recorded in the third quarter of 2006, for which we receive no tax benefit. Our effective tax rate was 59.5% for the year ended December 31, 2005. While we were a subsidiary of Liberty, we calculated our deferred tax liabilities using Liberty’s blended weighted average state tax rate. Subsequent to our spin off, we assessed such rate in light of the fact that our operations are located primarily in California, which has a higher state income tax rate than many of the other states in which Liberty does business, and we determined that our effective tax rate should be increased from 39% to 39.55%. This increase resulted in additional deferred tax expense in 2005 of $15,263,000. In addition, our income tax rate in 2005 was higher than the federal income tax rate of 35% due to state and foreign tax expense.

Net Earnings (Loss).  We recorded net earnings (loss) of ($68,392,000), ($46,010,000) and $33,276,000 for the years ended December 31, 2007, 2006 and 2005, respectively. The change between each of these years is discussed in the aforementioned fluctuations in revenue and expenses.

 

Liquidity and Capital Resources

 

Our primary sources of funds are cash on hand and cash flows from operating activities. During the year ended December 31, 2007, our primary use of cash was capital expenditures of $47,115,000. Of the foregoing 2007 capital expenditures, $11,500,000 relates to the buildout of Ascent Media’s existing facilities for specific customer contracts. The remainder of our capital expenditures relate to purchases of new equipment and the upgrade of existing facilities and equipment. At December 31, 2007, we have approximately $209.4 million of cash and $23.5 million of marketable securities and for the foreseeable future, we expect to have sufficient available cash balances and net cash from operating activities to meet our working capital needs and capital expenditure requirements. We intend to seek external equity or debt financing in the event any new investment opportunities, additional capital expenditures or our operations require additional funds, but there can be no assurance that we will be able to obtain equity or debt financing on terms that are acceptable to us.

 

In 2008, Ascent Media and AccentHealth expect to spend approximately $52,000,000 for capital expenditures, which we expect will be funded with their cash from operations and cash on hand.

 

Our ability to seek additional sources of funding depends on our future financial position and results of operations, which, to a certain extent, are subject to general conditions in or affecting our industry and our customers and to general economic, political, financial, competitive, legislative and regulatory factors beyond our control.

 

We do not have access to the cash Discovery generates from its operations, unless Discovery makes a distribution with respect to its membership interests or makes other payments or advances to its members. Prior to May 14, 2007, DCI did not pay any dividends on its capital stock, and since that date, Discovery has not made any distributions to its members, and we do not have sufficient voting control to cause Discovery to make distributions or make other payments or advances to us.

 

Off-Balance Sheet Arrangements and Contractual Obligations

 

Information concerning the amount and timing of required payments under our contractual obligations at December 31, 2007 is summarized below:

 

 

We have contingent liabilities related to legal proceedings and other matters arising in the ordinary course of business. Although it is reasonably possible we may incur losses upon conclusion of such matters, an estimate of any loss or range of loss cannot be made. In the opinion of management, it is expected that amounts, if any, which may be required to satisfy such contingencies will not be material in relation to the accompanying consolidated financial statements.

 

Recent Accounting Pronouncements

 

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”), which defines fair value, establishes a framework for measuring fair value under GAAP and expands disclosures about fair value

measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements. The new guidance is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. We do not expect that our adoption of SFAS No. 157 will have a significant impact on the reported amounts of our assets and liabilities that we report at fair value in our consolidated balance sheet.

 

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141(R), “Business Combinations” (“SFAS No. 141(R)”). The statement will significantly change the accounting for business combinations, and under this statement, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. SFAS No. 141 (R) will change the accounting treatment for certain specific items, including acquisition costs, noncontrolling interests, acquired contingent liabilities, in-process research and development, restructuring costs and changes in deferred tax asset valuation allowances and income tax uncertainties after the acquisition date. The adoption of the requirements of SFAS No. 141 (R) applies prospectively to business combinations for which the acquisition date is on or after fiscal years beginning after December 15, 2008. Early adoption is prohibited.

 

Critical Accounting Polices and Estimates

 

Valuation of Long-lived Assets and Amortizable Other Intangible Assets.  We perform impairment tests for our long-lived assets if an event or circumstance indicates that the carrying amount of our long-lived assets may not be recoverable. In response to changes in industry and market conditions, we may also strategically realign our resources and consider restructuring, disposing of, or otherwise exiting businesses. Such activities could result in impairment of our long-lived assets or other intangible assets. We are subject to the possibility of impairment of long-lived assets arising in the ordinary course of business. We regularly consider the likelihood of impairment and recognize impairment if the carrying amount of a long-lived asset or intangible asset is not recoverable from its undiscounted cash flows in accordance with SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets”. Impairment is measured as the difference between the carrying amount and the fair value of the asset. We use both the income approach and market approach to estimate fair value. Our estimates of fair value are subject to a high degree of judgment. Accordingly, any value ultimately derived from our long-lived assets may differ from our estimate of fair value.

 

Valuation of Goodwill and Non-amortizable Other Intangible Assets.  We assess for impairment of goodwill annually and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include significant underperformance to historical or projected future operating results, substantial changes in our strategy or the manner of use of our assets, and significant negative industry or economic trends. Fair value of each reporting unit is determined through a combination of discounted cash flow models and comparisons to similar businesses in the industry.

 

Valuation of Trade Receivables.  We must make estimates of the collectibility of our trade receivables. Our management analyzes the collectibility based on historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms. We record an allowance for doubtful accounts based upon specifically identified receivables that we believe are uncollectible. In addition, we also record an amount based upon a percentage of each aged category of our trade receivables. These percentages are estimated based upon our historical experience of bad debts. Our trade receivables balance was $153,336,000, net of allowance for doubtful accounts of $8,994,000, as of December 31, 2007.

 

Valuation of Deferred Tax Assets.  In accordance with SFAS No. 109, “Accounting for Income Taxes”, we review the nature of each component of our deferred income taxes for reasonableness. After consideration of all available evidence, we have determined that it is more likely than not that we will not realize the tax benefits associated with certain cumulative net operating loss carry forwards and impairment reserves, and as such, we have established a valuation allowance of $117,551,000 and $96,223,000 as of December 31, 2007 and 2006, respectively.

Discovery

 

Overview

 

Effective May 15, 2007 and as a result of the Cox Transaction, our ownership interest in Discovery increased from 50% to 662/3%, and we continue to account for this investment using the equity method of accounting due to governance rights which restrict our ability to control Discovery. Accordingly, in our consolidated financial statements we record our share of Discovery’s net income or loss available to members and reflect this activity in one line item in our consolidated statement of operations as “Share of earnings of Discovery.” The following financial information of Discovery for the years ended December 31, 2007, 2006 and 2005 and related discussion is presented to provide the reader with additional analysis of the operating results and financial position of Discovery. Because we do not control the decision-making process or business management practices of Discovery, we rely on Discovery to provide us with financial information prepared in accordance with GAAP that we use in the application of the equity method. The information included in this section should be read in conjunction with the audited financial statements of Discovery for the year ended December 31, 2007 included elsewhere herein. The following discussion and analysis of Discovery’s operations and financial position has been prepared based on information that we receive from Discovery and represents our views and understanding of its operating performance and financial position based on such information. Discovery is not a separately traded public company, and we do not have the ability to cause Discovery’s management to prepare its own management’s discussion and analysis for our purposes. Accordingly, we note that the material presented in this section might be different if Discovery’s management had prepared it.

 

Discovery is a leading global media and entertainment company that provides original and purchased programming across multiple distribution platforms in the United States and more than 170 other countries, including television networks offering customized programming in 35 languages. Discovery’s strategy is to optimize the distribution, ratings and profit potential of each of its branded channels. Discovery also develops and sells consumer and educational products and services in the United States and internationally, and owns and operates a diversified portfolio of website properties and other digital services. Discovery operates through three divisions: (1) Discovery networks U.S., or U.S. networks, (2) Discovery networks international, or international networks, and (3) Discovery commerce and education.

 

Discovery’s media content is designed to target key audience demographics and the popularity of its programming creates a reason for advertisers to purchase commercial time on Discovery’s channels. Audience ratings are a key driver in generating advertising revenue and create demand on the part of cable television operators, direct-to-home or “DTH” satellite operators and other content distributors to deliver Discovery’s programming to their customers.

 

In addition to growing distribution and advertising revenue for its branded channels, Discovery is focused on growing revenue across new distribution platforms, including brand-aligned web properties, mobile devices, video-on-demand and broadband channels, which serve as additional outlets for advertising and affiliate sales, and provide promotional platforms for its programming. Discovery also operates internet sites providing supplemental news, information and entertainment content that are aligned with its television programming. Discovery’s recent acquisition of HowStuffWorks.com creates a stronger platform for distributing Discovery’s extensive video library.

 

 

U.S. networks is Discovery’s largest division, which owns and operates 11 cable and satellite channels, including Discovery Channel, TLC and Animal Planet, as well as a portfolio of website properties and other digital services. U.S. networks also provides distribution and advertising sales services for Travel Channel and BBC America and provides distribution services for BBC World News. U.S. networks derives revenue primarily from distribution fees and advertising sales, which comprised 44% and 51%, respectively, of revenue for this division for the year ended December 31, 2007. During each of the years ended December 31, 2007, 2006 and 2005, Discovery Channel and TLC collectively generated more than 65% of U.S. networks total revenue. U.S. networks earns distribution fees under multi-year affiliation agreements with cable operators, DTH satellite operators and other distributors of television programming. Distribution fees are based on the number of subscribers receiving Discovery’s programming. Upon the launch of a new channel, Discovery may initially pay distributors to carry

such channel (such payments are referred to as “launch incentives”), or may provide the channel to the distributor for free for a predetermined length of time. Launch incentives are amortized on a straight-line basis as a reduction of revenue over the term of the affiliation agreement. U.S. networks sells commercial time on its networks and websites. The number of subscribers to Discovery’s channels, the popularity of its programming and its ability to sell commercial time over a group of channels are key drivers of advertising revenue.

 

Several of Discovery’s domestic networks, including Discovery Channel, TLC and Animal Planet, are currently distributed to substantially all of the cable television and direct broadcast satellite homes in the U.S. Accordingly, the rate of growth in U.S. distribution revenue in future periods is expected to be less than historical rates. Discovery’s other U.S. networks are distributed primarily on the digital tier of cable systems and equivalent tiers on DTH platforms and have been successful in maximizing their distribution within this more limited universe. There is, however, no guarantee that these digital networks will ever be able to gain the distribution levels or advertising rates of Discovery’s major networks. Discovery’s contractual arrangements with U.S. distributors are renewed or renegotiated from time to time in the ordinary course of business. Although U.S. networks believes carriage and marketing of its networks by the larger affiliates will continue, the loss of one or more affiliate agreements could have a material adverse impact on U.S. networks results of operations. In 2008, Discovery will enter negotiations to renew distribution agreements for carriage of its networks involving a substantial portion of its domestic subscribers. A failure to secure a renewal or a renewal on less favorable terms may have a material adverse effect on Discovery’s results of operations and financial position.

 

U.S. networks largest single cost is the cost of programming, including production costs for original programming. U.S. networks amortizes the cost of original or purchased programming based on the expected realization of revenue resulting in an accelerated amortization for Discovery Channel, TLC and Animal Planet and straight-line amortization over three to five years for the remaining networks.

 

U.S. networks’ top strategic priorities are (1) maintaining the company’s focus on creative excellence in nonfiction programming and expanding the portfolio’s brand entitlement by developing compelling content that increases audience growth, builds advertising relationships and supports continued distribution revenue on all platforms, (2) leveraging Discovery’s distribution strength in the U.S. to build additional branded channels and businesses that can sustain long-term growth and profitability, and (3) developing and growing compelling and profitable content experiences on new platforms that are aligned with its core branded channels.

 

 

International networks manages a portfolio of channels, led by the Discovery Channel and Animal Planet brands, that are distributed in virtually every pay-television market in the world through an infrastructure that includes major operational centers in London, Singapore, New Delhi and Miami. International networks regional operations cover most major markets including the U.K., Europe, Middle East and Africa (“EMEA”), Asia, Latin America and India. International networks currently operates over 100 unique distribution feeds in 35 languages with channel feeds customized according to language needs and advertising sales opportunities. Most of the division’s channels are wholly owned by Discovery with the exception of (1) the international Animal Planet channels, which are generally joint ventures in which the BBC owns 50%, (2) People + Arts, which operates in Latin America and Iberia as a 50-50 joint venture with the BBC and (3) several channels in Japan, Canada and Poland, which operate as joint ventures with strategically important local partners.

 

Similar to U.S. networks, the primary sources of revenue for international networks are distribution fees and advertising sales, and the primary cost is programming. International networks executes a localization strategy by offering customized content and localized schedules via its distribution feeds. Distribution revenue represents approximately 60% of the division’s operating revenue and continues to deliver growth in markets with the highest potential for pay television expansion. Advertising sales are increasingly important to the division’s financial success. International television markets vary in their stages of development. Some, notably the U.K., are among the more advanced digital multi-channel television markets in the world, while others remain in the analog environment with varying degrees of investment from operators in expanding channel capacity or converting to digital. Discovery believes there is future growth in many markets including Latin American and Central and Eastern Europe that are in the early stage of pay TV evolution. In developing pay TV markets, Discovery expects to see

advertising revenue growth from its localization strategy and the shift of advertising spending from broadcast to pay TV. In relatively mature markets, such as the U.K., the growth dynamic is changing. Increased penetration and distribution are unlikely to drive rapid growth in those markets. Instead, growth is expected in advertising sales, which are driven by increased audience performance and viewing market share. To help further drive this focus, Discovery entered the global free-to-air television business with the acquisition of a free-to-air channel in Germany (“DMAX”) in early 2006.

 

Discovery’s international businesses are subject to a number of risks including fluctuations in currency exchange rates, regulatory issues, and political instability. The past few years have seen relative economic and political stability, but these trends may not be indicative of future events. Changes in any of these areas could adversely affect the performance of the international networks.

 

International networks’ priorities include maintaining a leadership position in nonfiction entertainment in international markets, and continuing to grow and improve the performance of the international operations. These priorities will be achieved through expanding local advertising sales capabilities, creating licensing and digital growth opportunities, and improving operating efficiencies by strengthening development and promotional collaboration between U.S. and international network groups.

 

 

During 2007, Discovery evaluated its commerce business and made the decision to transition from running brick-and-mortar retail locations to leveraging its products through retail arrangements and an e-commerce platform. In the third quarter, Discovery completed the closing of its 103 mall-based and stand-alone Discovery Channel stores. As a result of the store closures, Discovery’s results of operations have been prepared to reflect the retail store business as discontinued operations. Accordingly, the revenue, costs and expenses of the retail store business have been excluded from the respective captions in Discovery financial statements and have been reported as discontinued operations.

 

Discovery commerce is now focused on its e-commerce, catalog, and domestic licensing businesses. Discovery commerce leverages its partnerships with leading e-commerce portals such as Amazon and QVC, to showcase key products, increase customer outreach, acquisition and conversion and maximize transaction opportunities. Discovery commerce adds value to Discovery’s television assets by reinforcing consumer loyalty and creating opportunities for Discovery’s advertising and distribution partners.

 

Discovery’s education business will continue to focus on its direct-to-school distribution platform and its other premium direct-to-school subscription services in addition to publishing and distributing content on DVD, VHS, online and through a network of distribution partners. Discovery education also participates in licensing and sponsorship programs with corporate partners.

 

Acquisitions

 

To complement its existing businesses, Discovery completed several acquisitions in 2006 and 2007. Among these acquisitions are (i) DMAX, a free-to-air network in Germany, which was acquired in February 2006, (ii) Antenna Audio, a provider of audio tours and multimedia at museums and cultural attractions around the globe, which was acquired in March 2006, (iii) PetFinder.com, a facilitator of pet adoptions and PetsIncredible, a producer of pet-training videos were acquired in November 2006, (iv) TreeHugger.com, an eco-lifestyle website to supplement the Planet Green initiative was acquired in August 2007 and (v) HowStuffWorks.com, an online source of easy-to-understand explanations of how the world works, which was acquired in December 2007. These entities have been included in Discovery’s results of operations since their respective dates of acquisition.

 

Dispositions

 

On May 14, 2007 Discovery and Cox Communications Holdings, Inc. (“Cox”) completed an exchange of Cox’s 25% ownership interest in Discovery for all of the capital stock of a subsidiary of Discovery that held Travel Channel, travelchannel.com and approximately $1.3 billion in cash (the “Cox Transaction”). Discovery raised the cash component through additional debt financing, and retired the membership interest previously owned by Cox.

Results of Operations

 

The following discussion of Discovery’s results of operations is presented in two parts to assist the reader in better understanding Discovery’s operations. The first section is an overall discussion of Discovery’s consolidated operating results. The second section includes a more detailed discussion of revenue and operating cash flow activity of Discovery’s three operating divisions: U.S. networks, international networks, and commerce and education.

 

 

Discovery was formed in the second quarter of 2007 as part of a restructuring (the “DCI Restructuring”) completed by Discovery Communications, Inc. (“DCI”). In the DCI Restructuring, DCI became a wholly-owned subsidiary of Discovery, and the former shareholders of DCI, including DHC, became members of Discovery. Discovery is the successor reporting entity to DCI. In connection with the DCI Restructuring, Discovery applied “pushdown” accounting and each shareholder’s basis in DCI as of May 14, 2007 has been pushed down to Discovery resulting in $4.3 billion of goodwill being recorded by Discovery. Since goodwill is not amortizable, there is no current income statement impact for this change in basis.

 

During 2007, Discovery undertook broad restructuring activities to better position its portfolio of assets and to facilitate growth and enhanced profitability. These activities resulted in additional operating expenses that impact the comparability of results from 2006 to 2007. The more significant items include fourth quarter 2007 content impairment charges of $129,091,000 at U.S. networks and $9,976,000 at Education, which are included in cost of revenue, $20,424,000 in 2007 restructuring charges, and an asset impairment charge in the second quarter of 2007 of $26,174,000 related to write-offs of education intangible assets.

The combining of predecessor and successor accounting periods is not permitted by GAAP. However, to provide a more meaningful basis for comparing 2007 to 2006 and 2005, Discovery’s operating results for the seven and one-half months ended December 31, 2007 have been combined with the four and one-half months ended May 14, 2007 in the following tables and discussion.

 

 

Revenue.  Discovery’s consolidated revenue increased 8% for the year ended December 31, 2007, as compared to 2006, due to increases of 8% in advertising revenue, 48% in other revenue and 3% in distribution revenue. Increases in advertising revenue were primarily due to increased ratings and advertising rates at the U.S. networks, particularly at Discovery Channel and TLC, combined with increased growth in local ad sales in Europe and the impact of favorable exchange rates, partially offset by the disposition of Travel Channel. Program ratings are an indication of consumer acceptance and directly affect Discovery’s ability to generate revenue during the airing of its programs. If programs do not achieve sufficient acceptance, the revenue from advertising sales may decline. International networks advertising sales increased due to the continued growth in audience, driven by growth in subscription units. Increased distribution revenue is primarily due to international networks subscriber growth and favorable exchange rates, partially offset by the disposition of Travel Channel and an increase in contra revenue items. Launch incentives increased in 2007 due to the renewal of long-term distribution agreements for certain U.K. networks which resulted in a payment of $195.8 million, most of which is being amortized over a five-year period. Other revenue increased due to (i) the full year impact of the 2006 acquisition of Antenna Audio and (ii) Discovery’s new Travel Channel representation arrangement.

In 2006, consolidated revenue increased 13%, as compared to 2005, due to a 20% increase in distribution revenue, a 5% increase in advertising revenue and a 30% increase in other revenue. Increased distribution revenue is primarily due to contractual rate increases, subscriber growth at both U.S. networks and international networks and a reduction in launch support amortization as certain U.S. networks affiliation agreements were extended at no additional cost to Discovery. Distribution revenue also benefited from contractual arrangements in the U.S. networks whereby certain subscribers that were previously covered under free carriage periods with distributors were converted to paying subscribers. Increases in advertising revenue were primarily due to increased advertising rates at the U.S. networks combined with positive developments in international networks advertising sales resulting from continued growth in subscription units. Other revenue increased due to acquisitions in 2006.

 

Cost of revenue.  Cost of revenue, which includes content amortization and other production related expenses in addition to distribution and merchandising costs, increased 14% in 2007, as compared to 2006. Such increase is primarily a result of higher programming costs, including a fourth quarter 2007 impairment charge of $129,091,000 at U.S. networks where new channel leadership has implemented strategic plans to maximize viewership and ratings across most networks. In the fourth quarter of 2007 and in connection with these initiatives, Discovery evaluated its programming portfolio assets and determined that the carrying values of certain programming assets exceeded their estimated fair values which resulted in such impairment charge. Contributing to the increase in cost of revenue is also the impact of several new networks launched in Europe in 2006 and 2007, and the unfavorable impact of foreign currency exchange rates. Partially offsetting these increases is a decrease due to the disposition of Travel Channel. As a result of the foregoing fluctuations, cost of revenue as a percent of revenue increased to 38% in 2007 from 36% in 2006.

 

During 2006, cost of revenue increased 14%, as compared to 2005, which is consistent with the 2006 percentage increase in revenue. Such increase in cost of revenue is primarily a result of higher programming costs for Discovery’s U.S. networks due to continued investment in original productions and high profile specials, combined with increases in Europe associated with the launch of several networks including DMAX. Additionally, cost of revenue in 2005 was reduced by a net aggregate benefit of approximately $11 million related to reductions in estimates for music rights accruals.

 

SG&A expenses.  SG&A expenses, which include personnel, marketing and other general and administrative expenses, increased 4% in 2007, as compared to 2006. Such increase is due to higher personnel costs which resulted from merit, benefit and performance-based compensation increases in U.S. networks and international networks driven by expanding business activity through acquisition, increased international advertising sales coverage, expansion of network teams to support the new brand strategies and digital media. Also contributing to the increase is the impact of unfavorable foreign currency exchange rates. These increases were partially offset by lower marketing expenses at U.S. networks and lower marketing and personnel expenses in the education division as a result of cost cutting measures implemented in 2007. As a percent of revenue, SG&A expense was 37% in 2007, down from 38% in 2006. Although no assurance can be given, Discovery believes that as a result of its ongoing cost containment initiatives, SG&A expense as a percent of revenue will continue to decrease in 2008.

 

During 2006, SG&A expenses increased 19%, as compared to 2005, due primarily to international infrastructure expansions which increased headcount and office locations to support growth in local advertising sales operations driving increased revenue. Additionally, personnel and marketing costs increased at Discovery’s education division, particularly due to its investment in its Cosmeo homework help service. As a result, SG&A as a percent of revenue increased from 37% in 2005 to 38% in 2006.

 

Expenses arising from long-term incentive plans.  Expenses arising from long-term incentive plans are related to Discovery’s unit-based, long-term incentive plan, or LTIP, for its employees who meet certain eligibility criteria. Such plan was established in 2005 (the “2005 LTIP Plan”) and replaced the former LTIP Plan under which unit values were tied to Discovery’s equity value. Units are awarded to eligible employees and generally vest at a rate of 25% per year. The value of units in the 2005 LTIP Plan is indexed to the value of DHC Series A common stock and is calculated using the Black Scholes Model. The change in unit value of LTIP awards outstanding is recorded as compensation expense over the period outstanding. Upon redemption of the LTIP awards, participants receive a cash payment based on the value of the award as described in the terms of the 2005 LTIP Plan. In the third quarter of 2007, Discovery amended the 2005 LTIP such that the redemption dates occur annually over a 4 year

period instead of bi-annually over an 8 year period. Compensation expense aggregated $141,377,000, $39,233,000, and $49,465,000 for the years ended December 31, 2007, 2006, and 2005, respectively. The increase in 2007 is primarily the result of increases in the DHC Series A common stock price offset by a decrease in expense related to the shortened redemption time period under the amended 2005 LTIP Plan. The decrease in 2006 is primarily the result of the change in unit value determination for the 2005 LTIP Plan units. If the remaining vested LTIP awards at December 31, 2007 were redeemed, the aggregate cash payments by Discovery would be approximately $94,190,000.

 

Restructuring charges.  During 2007, Discovery recorded restructuring charges of $20,424,000 related to a number of organizational and strategic adjustments which consisted mainly of severance due to a reduction in headcount. The purpose of these adjustments was to better align Discovery’s organizational structure with the company’s new strategic priorities and to respond to continuing changes within the media industry. There was no similar restructuring charge in 2006.

 

Asset impairment.  During the second quarter of 2007, Discovery recorded a $26,174,000 asset impairment charge which represents write-offs of education intangible assets related to its consumer business due to Discovery’s decision to decrease its investment in certain product offerings.

 

Depreciation and amortization.  The increase in depreciation and amortization in both 2007 and 2006 is due to an increase in intangible assets resulting from acquisitions combined with increases in Discovery’s depreciable asset base resulting from capital expenditures.

 

Gain from disposition of business.  Discovery recognized a gain from disposition of business of $134,671,000 during 2007 in connection with the Cox Transaction and the sale of the Travel Channel.

 

 

Interest expense.  On May 14, 2007, Discovery entered into a new $1.5 billion term loan in connection with the Cox Transaction. The increase in interest expense for the twelve months ended December 31, 2007 is primarily a result of the new term loan. The increase in interest expense during the year ended December 31, 2006 is primarily due to higher levels of outstanding debt combined with increases in interest rates during the period.

 

Unrealized gains from derivative instruments, net.  Unrealized gains from derivative transactions relate, primarily, to Discovery’s use of derivative instruments to modify its exposure to interest rate fluctuations on its debt. These instruments include a combination of swaps, caps, collars and other structured instruments. As a result of unrealized mark to market adjustments, Discovery recognized an unrealized loss of $8,617,000 during the year ended December 31, 2007 and unrealized gains of $10,352,000 and $29,109,000 during the years ended December 31, 2006 and 2005, respectively. The foreign exchange hedging instruments used by Discovery are spot, forward and option contracts. Additionally, Discovery enters into non-designated forward contracts to hedge non-dollar denominated cash flows and foreign currency balances.

 

Minority interests in consolidated subsidiaries.  Minority interests primarily represent increases and decreases in the estimated redemption value of mandatorily redeemable interests in subsidiaries which are initially recorded at fair value, as well as the portion of earnings of consolidated entities which are allocable to the minority partners.

 

Other.  Other income in 2007, 2006 and 2005 relates primarily to Discovery’s equity share of earnings of its joint ventures.

 

Income taxes.  Discovery’s effective tax rate was 21%, 45% and 49% for 2007, 2006 and 2005, respectively. Discovery’s effective tax rate differed from the federal income tax rate of 35% primarily due to the tax-free treatment of the disposition of the Travel Channel and the corresponding reversal of deferred tax liabilities in 2007 and due to foreign and state taxes in 2006 and 2005.

Loss from discontinued operations.  Summarized financial information for the retail stores business included in discontinued operations is as follows:

 

 

The 2007 loss from discontinued operations includes $39,904,000 in restructuring costs and $28,264,000 in asset impairment charges, along with normal business operations.

 

Net earnings.  Discovery’s net earnings were $221,991,000, $207,176,000, and $159,620,000, for 2007, 2006 and 2005, respectively. The changes in net earnings are due to the aforementioned fluctuations in revenue and expense.

 

Operating Division Results

 

As noted above, Discovery’s operations are divided into three groups: U.S. networks, international networks and commerce and education. Corporate expenses primarily consist of corporate functions, executive management and administrative support services. Corporate expenses are excluded from segment results to enable executive management to evaluate business segment performance based upon decisions made directly by business segment executives. Certain prior period amounts have been reclassified between segments to conform to Discovery’s 2007 operating structure.

 

Discovery Consolidated

 

 

 

As noted above, in May 2007, Discovery exchanged its subsidiary holding the Travel Channel, travelchannel.com and approximately $1.3 billion in cash for Cox’s interest in Discovery. Accordingly, Discovery’s 2007 results of operations do not include Travel Channel for the full year. The disposal of Travel Channel does not meet the requirements for discontinued operations presentation. The following table presents U.S. networks results of operations excluding Travel Channel for all periods. This presentation is not in accordance with GAAP. However, Discovery believes this presentation provides a more meaningful comparison of the U.S. networks results of operations and allows the reader to better understand the U.S. networks ongoing operations.

 

 

 

The following discussion excludes the results of Travel Channel for all periods.

 

Revenue.  In 2007, advertising revenue increased 13%, distribution revenue increased 3%, and other revenue increased 60%, as compared to 2006. The increase in advertising revenue at the U.S. networks was primarily due to improved advertising sell-out rates, better unit pricing and higher audience delivery on most channels, notably the Discovery Channel and TLC. The advertising market was strong and scatter pricing was well above upfront pricing. Primetime sell-outs on the major networks increased by an average of seven percentage points. Primetime ratings increased on Discovery Channel due to original content such as Planet Earth, Deadliest Catch, Man vs. Wild, Dirty Jobs and Mythbusters. TLC Primetime ratings increased due to original content such as Little People Big World, What Not to Wear and L.A. Ink. Advertising revenue growth on certain networks carried on the digital tier was 36% led by The Science Channel and Discovery Times. Distribution revenue was driven by a 6% increase in average paying subscription units, principally from networks carried on the digital tier, partially offset by an increase in contra-revenue items. Contra-revenue items included in distribution revenue, such as launch amortization and

marketing consideration, increased from $86,399,000 in 2006 to $95,213,000 in 2007. Other revenue primarily increased as a result of increased revenue from Discovery’s representation of the Travel Channel.

 

In 2006, distribution revenue increased 17% and advertising revenue increased 1%, as compared to 2005. Distribution revenue was driven by a 13% increase in average paying subscription units, principally from networks carried on the digital tier, combined with contractual rate increases, partially offset by an increase in contra-revenue items from $75,705,000 in 2005 to $86,399,000 in 2006. Advertising was flat although ratings were higher compared to 2005. During the fourth quarter of 2006, the advertising sales market began to reflect the ratings turnaround, and advertising revenue in the fourth quarter increased 14%, as compared to the fourth quarter of 2005.

 

Cost of revenue.  In 2007, cost of revenue increased 27%, as compared to 2006, primarily due to a $122,099,000 increase in content amortization expense, including an impairment charge of $129,091,000. In 2007, following several changes in channel leadership, Discovery undertook strategic reviews to maximize viewership and ratings across most networks. As a result, programming at the Discovery Channel, TLC and Animal Planet is being re-positioned to better align content with these channel brands. In addition, certain other networks are being re-branded, including the transition of the Discovery Times channel to Investigation Discovery, the Discovery Home channel to Planet Green, and the recently announced creation of OWN: The Oprah Winfrey Network, a joint venture between Discovery and Harpo Productions, Inc. on what is currently the Discovery Health channel. In the fourth quarter of 2007 and in connection with these initiatives, Discovery evaluated its programming portfolio assets and determined that the carrying values of certain programming assets exceeded their estimated fair values which resulted in the aforementioned impairment charge. The program impairment was primarily related to content that was capitalized in 2006 and 2007 and would have been amortized over the next 3 years. Excluding the 2007 impairment charge and accelerated amortization of certain programs in 2007 and 2006, content amortization increased due to continued investment in original programs that are aligned with the future strategy and from 2006 acquisitions.

 

Cost of revenue increased 7% in 2006, as compared to 2005, primarily as a result of a $51,222,000 increase in content amortization expense due to continued investment in original productions on the widely distributed channels and accelerated amortization on certain programs. These increases were partially offset by a decrease of $9,064,000 in transponder and uplink costs due to cost savings associated with Discovery’s launch of its broadcast facility in 2005.

 

SG&A expenses.  SG&A expenses increased 15% in 2007, as compared to 2006. The increase is due to personnel cost increases of $35,410,000 driven by merit, benefit and performance-based compensation increases, along with the impact of the expansion of its network teams to support the new brand strategies and continued investment in digital media. Also contributing to the increase were higher research expenses of $11,157,000 resulting from contractual increases for ratings research and additional fees associated with providing commercial minute ratings. These increases were partially offset by a decrease in marketing expense of $7,636,000 which coincided with a re-evaluation of the related programming strategies.

 

The 2006 3% increase in SG&A expenses is primarily due to a 12% or $13,581,000 increase in personnel expense resulting from compensation and benefit increases.

 

Digital Media Business.  Revenue for the U.S. networks digital media businesses totaled approximately $31 million in 2007 and $19 million in 2006. Operating expenses for these businesses were $43 million and $28 million for 2007 and 2006, respectively. Discovery expects these amounts to increase in the future due to its recent acquisitions of PetFinder.com, TreeHugger.com and HowStuffWorks.com, as well as any future organic investments in this arena, with operating cash flow losses remaining below 5% of Discovery’s consolidated operating cash flow.

 

 

Revenue.  In 2007, advertising revenue increased 19%, as compared to 2006, due primarily to higher viewership in Europe and Latin America combined with an increased subscriber base in most markets worldwide, favorable exchange rate impacts and a full year of activity related to DMAX. These increases were partially offset by a decline in advertising revenue in the U.K. which was driven by lower ratings for Discovery Channel resulting from increased competition and a continuing shift in viewing habits due to channel placement on the Electronic Programming Guide which lists scheduled programs on each channel. Distribution revenue increased 8% in 2007 principally comprised of combined revenue growth in Europe, Latin America and Asia of $71,927,000 and favorable foreign exchange impact of $29,402,000, primarily in the U.K. and Europe, partially offset by a $55,684,000 revenue decline in the U.K. The net increase in revenue resulted from an overall increase in average paying subscription units of 13% primarily due to pay TV subscriber growth in many markets in Europe and Latin America combined with contractual rate increases in certain markets, partially offset by an increase in launch amortization. In January 2007 and in connection with the settlement of terms under a pre-existing distribution agreement, Discovery completed negotiations for the renewal of long-term distribution agreements for certain U.K. networks and paid a distributor $195.8 million. Most of the payment was attributed to the renewal period and is being amortized over a five year term. As a result, launch amortization at the international networks increased from $6,474,000 in 2006 to $44,291,000 in 2007. Other revenue increased $23,614,000 primarily due to the full year impact of Antenna Audio, which was acquired in March 2006.

 

In 2006, distribution revenue increased 23%, as compared to 2005, primarily due to combined revenue growth in Europe and Latin America of $79,235,000 resulting from a 27% increase in average paying subscription units, primarily on networks with lower rates, in those markets. Subscriber growth in those markets was driven by increased penetration and distribution along with the full year impact of new channel launches in Italy, France and Germany. Favorable foreign exchange impacts of $6,533,000, primarily in Europe and Latin America, also contributed to the increase in distribution revenue. Advertising revenue increased 14% in 2006 primarily due to higher viewership in Europe and Latin America combined with an increased subscriber base in most markets worldwide. Other revenue increased 95% due primarily to the inclusion of $32,371,000 in revenue from the acquisition of Antenna Audio in April 2006.

 

Cost of revenue.  In 2007, cost of revenue increased 5%, as compared to 2006, primarily due to the full year impact of $15,613,000 from DMAX and Antenna Audio, which were acquired in 2006.

 

In 2006, cost of revenue increased 24%, as compared to 2005, primarily from a $27,434,000 increase in content amortization expense. The amortization expense increase is associated with additional programming to support the launch of several lifestyle-focused networks including $10,142,000 related to DMAX and Antenna Audio. Other increases in cost of revenue related to DMAX and Antenna Audio aggregated $23,394,000.

 

SG&A expenses.  SG&A expenses increased 13% during 2007, as compared to 2006. The increase is primarily due to a $43,507,000 increase in personnel expense, of which $19,428,000 resulted from a full year of activity related to the DMAX and Antenna Audio acquisitions in 2006. Personnel costs in Europe increased

$18,610,000 due to infrastructure expansions of sales personnel allowing for increased targeting of advertising consistent with geographic demand to support revenue growth.

 

In 2006, SG&A expenses increased 25%, as compared to 2005, primarily due to a $46,568,000 or 44% increase in personnel expense, resulting from infrastructure expansions in Europe to support revenue growth combined with the acquisition of Antenna Audio. Marketing expense increased $6,087,000 or 7% due to marketing campaigns in Europe and Asia for the launch of new channels. General and administrative expenses increased $21,161,000 or 20% primarily due to the inclusion of Antenna Audio coupled with the unfavorable effect of foreign currency exchange rates.

 

During the years ended December 31, 2007 and 2006, the international networks revenue and operating cash flow were impacted favorably by changes in the exchange rates of various foreign currencies. In the event the U.S. dollar strengthens against certain foreign currencies in the future, the international networks group’s revenue and operating cash flow will be negatively impacted. Had there been no impact from changes in exchange rates, international networks would have increased revenue and operating expenses 8% and 4%, respectively, during the year ended December 31, 2007, as compared to 2006, and 22% and 23%, respectively, during the year ended December 31, 2006, as compared to 2005.

 

 

 

Revenue.  In 2007, commerce and education revenue increased 40%, as compared to 2006, due to a $17,595,000 increase in education revenue as a result of an increase in subscribers and improved pricing for Discovery’s direct-to-school education distribution platform, and a $24,925,000 increase in commerce revenue which was driven by an increase in sales of Planet Earth DVDs following the series premiere in March 2007.

 

In 2006, Commerce and education revenue increased 21%, as compared to 2005, due to a $10,578,000 increase in revenue related to the education business as a result of a 30% increase in average paying school subscribers and the impact of acquisitions in 2006. Also contributing to the increase was an $8,131,000 increase in revenue related to the commerce business mainly driven by increased ecommerce sales.

 

Cost of revenue.  During the fourth quarter of 2006, Discovery made a number of organizational and strategic adjustments to its education business to focus resources on the company’s direct-to-school distribution platform, unitedstreaming, as well as the division’s other premium direct-to-school subscription services. In 2007, cost of revenue increased 14%, or $11,516,000, as compared to 2006, primarily due to increased content amortization related to an impairment charge of $9,976,000 as a result of the re-focus of the education business.

 

In 2006, cost of revenue increased 33%, or $19,893,000, as compared to 2005, primarily as a result of a $14,127,000 investment in education content to accommodate the growth of the education business.

 

SG&A expenses.  In 2007, SG&A expenses decreased 43%, as compared to 2006, primarily due to a $10,671,000 reduction in personnel expense as a result of business restructuring in commerce and education, combined with a $26,649,000 reduction in marketing expense as Discovery re-focused the direction of the education business. Included in SG&A are approximately $5 million in costs incurred during the fourth quarter of 2007 to transition the back-office and distribution services of the remaining commerce business to Discovery’s headquarters and/or third-party service providers.

In 2006, SG&A expenses increased 85%, as compared to 2005. Expenses in the education division increased as a result of (i) a 91%, or $18,056,000, increase in personnel expense, resulting primarily from a full year of salary expense for employees hired in 2005 and (ii) a 174%, or $19,142,000, increase in marketing expense resulting primarily from Discovery’s investment in Cosmeo, a new consumer homework help service.

 

Corporate

 

Corporate operating cash flow losses increased 11%, or $17,650,000, in 2007, as compared to 2006, primarily due to costs incurred as a result of supporting Discovery’s shareholder transactions combined with increases in performance-based compensation resulting from strong fiscal year financial performance and the impact of changes in executive management including related hiring costs. The 2006 increase of 14% or $20,418,000 was driven primarily by merit, benefit and performance-based compensation increases.

 

Liquidity and Capital Resources

 

Discovery’s principal sources of liquidity are cash flows from operations and borrowings under its credit facility, and its principal uses of cash are for capital expenditures, acquisitions, debt service requirements, and other obligations. Discovery anticipates that its operating cash flows, existing cash, cash equivalents and borrowing capacity under its revolving credit facility are sufficient to meet its anticipated cash requirements for at least the next 12 months.

 

During the year ended December 31, 2007, Discovery’s primary uses of cash were the redemption of Cox’s equity interests ($1,284,544,000), acquisitions ($306,094,000, net of cash acquired) and capital expenditures ($80,553,000). Discovery funded these investing and financing activities with cash from operations of $242,072,000 and bank borrowings of $1,497,639,000.

 

Discovery’s various debt facilities include two term loans, two revolving loan facilities and various senior notes payable. The second term loan was entered into on May 14, 2007 for $1.5 billion in connection with the Cox Transaction. Total commitments of these facilities were $5,596,398,000 at December 31, 2007. Debt outstanding on these facilities aggregated $4,094,174,000 at December 31, 2007, providing excess debt availability of $1,502,224,000. Discovery’s ability to borrow the unused capacity is dependent on its continuing compliance with its covenants at the time of, and after giving effect to, a requested borrowing.

 

Discovery’s $1.5 billion term loan is secured by the assets of Discovery, excluding assets held by its subsidiaries. The remaining term loan, revolving loans and senior notes are unsecured. The debt facilities contain covenants that require the respective borrowers to meet certain financial ratios and place restrictions on the payment of dividends, sale of assets, additional borrowings, mergers, and purchases of capital stock, assets and investments. Discovery has indicated that it was in compliance with all debt covenants as of December 31, 2007.

 

Discovery’s outstanding notes payable and long-term debt at December 31, 2007 consists of the following (amounts in thousands):

 

In 2008, Discovery expects its uses of cash to be approximately $266,285,000 for debt repayments, $90,000,000 for capital expenditures and $260,000,000 for interest expense. Discovery will also be required to make payments under its LTIP Plan. However, amounts expensed and payable under the LTIP are dependent on future annual calculations of unit values which are affected primarily by changes in DHC’s stock price, annual grants of additional units, redemptions of existing units, and changes to the plan. If the remaining vested LTIP awards at December 31, 2007 were redeemed, the aggregate cash payments by Discovery would be approximately $94,190,000. Discovery believes that its cash flow from operations and borrowings available under its credit facilities will be sufficient to fund its cash requirements, including LTIP obligations.

 

The Company’s interest expense is exposed to movements in short-term interest rates. Derivative instruments, including both fixed to variable and variable to fixed interest rate instruments, are used to modify this exposure. The variable to fixed interest rate instruments have a notional principal amount of $2.27 billion and have a weighted average interest rate of 4.68% against 3 month LIBOR at December 31, 2007. The fixed to variable interest rate agreements have a notional principal amount of $225.0 million and have a weighted average interest rate of 9.65% against fixed rate private placement debt at December 31, 2007. At December 31, 2007, the Company held an unexercised interest rate swap put with a notional amount of $25.0 million at a fixed rate of 5.44%.

 

Discovery’s access to capital markets can be affected by factors outside of its control. In addition, its cost to borrow is impacted by market conditions and its financial performance as measured by certain credit metrics defined it its credit agreements, including interest coverage and leverage ratios.

 

Contractual obligations.  Discovery has agreements covering leases of satellite transponders, facilities and equipment. These agreements expire at various dates through 2020. Discovery is obligated to license programming under agreements with content suppliers that expire over various dates. Discovery also has other contractual commitments arising in the ordinary course of business.

 

A summary of all of the expected payments for these commitments as well as future principal payments under the current debt arrangements and minimum payments under capital leases at December 31, 2007 is as follows:

 

 

 

 

Discovery is subject to a contractual agreement that may require Discovery to acquire the minority interest of certain of its subsidiaries. The amount and timing of such payments are not currently known. Discovery has recorded an estimated liability as of December 31, 2007 for this redemption right.

 

 

Foreign Currency Risk

 

We continually monitor our economic exposure to changes in foreign exchange rates and may enter into foreign exchange agreements where and when appropriate. Substantially all of our foreign transactions are denominated in foreign currencies, including the liabilities of our foreign subsidiaries. Although our foreign transactions are not generally subject to significant foreign exchange transaction gains or losses, the financial statements of our foreign subsidiaries are translated into United States dollars as part of our consolidated financial reporting. As a result, fluctuations in exchange rates affect our financial position and results of operations.

 

 

Our consolidated financial statements are filed under this Item, beginning on Page II-28. The financial statement schedules required by Regulation S-X are filed under Item 15 of this Annual Report on Form 10-K.

 

 

None.

 

 

In accordance with Exchange Act Rules 13a-15 and 15d-15, the Company carried out an evaluation, under the supervision and with the participation of management, including its chief executive officer, principal accounting officer and principal financial officer (the “Executives”), of the effectiveness of its disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Executives concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2007 to provide reasonable assurance that information required to be disclosed in its reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

 

See page II-26 for Management’s Report on Internal Control Over Financial Reporting.

 

See page II-27 for Report of Independent Registered Public Accounting Firm for our accountant’s attestation regarding our internal controls over financial reporting.

 

There has been no change in the Company’s internal controls over financial reporting identified in connection with the evaluation described above that occurred during the three months ended December 31, 2007 that has materially affected, or is reasonably likely to materially affect, its internal controls over financial reporting.

 

 

None.

 

Discovery Holding Company’s management is responsible for establishing and maintaining adequate internal control over the Company’s financial reporting. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the consolidated financial statements and related disclosures in accordance with generally accepted accounting principles. The Company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of the consolidated financial statements and related disclosures in accordance with generally accepted accounting principles; (3) provide reasonable assurance that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (4) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the consolidated financial statements and related disclosures.

 

Because of inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies and procedures may deteriorate.

 

The Company assessed the design and effectiveness of internal control over financial reporting as of December 31, 2007. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework.

 

Based upon our assessment using the criteria contained in COSO, management has concluded that, as of December 31, 2007, Discovery Holding Company’s internal control over financial reporting is effectively designed and operating effectively.

 

Discovery Holding Company’s independent registered public accountants audited the consolidated financial statements and related disclosures in the Annual Report on Form 10-K and have issued an audit report on the Company’s internal control over financial reporting. This report appears on page II-27 of this Annual Report on Form 10-K.

 

The Board of Directors and Stockholders

Discovery Holding Company:

 

We have audited Discovery Holding Company’s internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Discovery Holding Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, Discovery Holding Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Discovery Holding Company and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of operations and comprehensive earnings (loss), cash flows and stockholders’ equity for each of the years in the three-year period ended December 31, 2007, and our report, which as it relates to the financial statements of Discovery Communications Holding, LLC (a 662/3 percent and 50 percent owned investee company as of December 31, 2007 and 2006, respectively) is based solely on the report of other auditors, dated February 14, 2008 expressed an unqualified opinion on those consolidated financial statements.

 

KPMG LLP

Denver, Colorado

February 14, 2008

 

The Board of Directors and Stockholders

Discovery Holding Company:

 

We have audited the accompanying consolidated balance sheets of Discovery Holding Company and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of operations and comprehensive earnings (loss), cash flows and stockholders’ equity for each of the years in the three-year period ended December 31, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We did not audit the financial statements of Discovery Communications Holding, LLC, (a 662/3 percent and 50 percent owned investee company as of December 31, 2007 and 2006, respectively). The Company’s investment in Discovery Communications Holding, LLC at December 31, 2007 and 2006, was $3,271,553,000 and $3,129,157,000, respectively, and its equity in earnings of Discovery Communications Holding, LLC was $141,781,000, $103,588,000 and $79,810,000 for the years ended December 31, 2007, 2006 and 2005, respectively. The financial statements of Discovery Communications Holding, LLC and its predecessor were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Discovery Communications Holding, LLC, is based solely on the report of the other auditors.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of the other auditors provide a reasonable basis for our opinion.

 

In our opinion, based on our audits and the report of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Discovery Holding Company and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.

 

Effective January 1, 2006, Discovery Holding Company adopted SFAS No. 123R, Share-Based Payment.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Discovery Holding Company’s internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 14, 2008 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

 

KPMG LLP

 

Denver, Colorado

February 14, 2008

DISCOVERY HOLDING COMPANY AND SUBSIDIARIES